Stock Option Pricing (2024)

Search Options Trading Mastery:

Why Understanding Stock Option Pricing is Vital to Success

Stock option pricing is one of those subjects that any aspiring trader should clearlyunderstand before venturing into the world of options trading. Optionsare not like other derivatives such as futures,spot forex, or contracts for difference, in that theirpricing components are much more complex.

So let's explore thesecomponents and having done so, see if we can identify how best to makethe most of them.

Stock Option Pricing - Intinsic and Extrinsic Values

Let's begin by looking at it simply. When the strike price of a callor put option is in a favorable relationship to the current market price of theunderlying stock, it is said to be "in-the-money".

For example, if youhad $20 call options and the current trading price of the underlyingcompany stock was $24 then your call options are $4 in-the-money (ITM).

For put options, the price of the stock would need to be $16 to be 'in the money' by the same amount. This $4 isthe "intrinsic value" of the options - i.e. the amount they would be worthat option expiration date.

If you owned $20call options for the above company shares and the market price had fallen from $20 to $16 then because the options have no real value if they were exercised, they are said to be "out of the money".

Now if these same options were trading in the market for $5.35 atany particular time, the extra $1.35 above $4 is known as the "extrinsic value" - often called "time value". It is a monetary value that represents the probability that the options will be in-the-money by expiration date.

The same applies when the option is "out-of-the-money" (OTM). It will have some exchange traded value, but it will all be extrinsic value.Since the further OTM options become, the less likely it is for them tohave any intrinsic value at expiration date, this will be reflected inthe option's extrinsic value.

The above is a 'broad brush' way of explaining option pricing.There are more specific factors that contribute to an option's value,including "the greeks", option volatility and remaining time to expiration. So let's get into the nitty gritty now ...

Stock Option Pricing - The Greeks

There are five option greeks that mathematically determine an option's price. They are called the delta, gamma, vega, theta and rho.

The Delta measures the change in the option's value inrelation to a one point move in the price of the underlying stock. Thefurther in-the-money an option goes, the greater the delta.

At-the-moneyoptions usually have a delta of 0.5 for call options or -0.5 for putoptions. This effectively means that for each $0.10 move of theunderlying, the option price will change by $0.05 (or half).

But whenthe option is, say, $2 in the money, the delta is more likely to bearound 0.90. This means "time value" becomes a less significantcomponent for "deep in the money" options.

The Gamma measures the rate of change of an option's deltawith respect to a one point move in the underlying. When you buy anoption, gamma is positive and when selling (going short) an option,gamma is negative, regardless of whether it's a call or put.

Theta measures how much an option loses its value on adaily basis as the expiration date approaches. Theta increasesexponentially the closer you get to expiration.

If you've bought anoption, theta tells you how many dollars you lose each day while theunderlying price action goes nowhere. This is why simple long positionsneed to not only be correct with regard to direction but also timing.

The converse applies when you've sold (written/gone short) an option.In this case, theta tells you how much money you make each day while the option remainsout-of-the-money.

Knowing how to read the theta in connection with the other"greeks" so that you know when it's necessary to adjust your positions,is the key to making a profit with "short" options positions. This is covered in depth, in the Trading Pro System videos.

The Vega is the most powerful of all the "Greeks". Vega measures the effect of implied volatilityon an option's price. If vega is positive then we will gain additionalprofit for every one point increase in the volatility of the market.

Rho

is about how much an option price changes in value as a result of a one point change in interest rates. As such, it is not a significant factor in stock option pricing unless big economic news is about.

Stock Option Pricing - Other Factors

The exchange traded options market is a market in itself, quite distinct fromthe stock market itself. As such, options are subject to the laws ofsupply and demand like any other financial instrument.

Options contracts are created by both 'market makers' and traders. If there are plenty of options available to take positions in, the market is said to be "liquid".

If there are notmany options to be traded, this may be reflected in the option price.If a lot of people suddenly want the call or put options of a particularstock, this will increase their price - in fact, it will be the implied volatility factor in the option price calculation.

Stock option pricing must also take into consideration whetherthe underlying stock is going to pay a dividend before expiration date.Before and after the dividend, the option pricing model must reflect the"cum dividend" and "ex dividend" nature of the stock.

Stock Option Pricing for Long and Short Positions

Have you ever bought an option contract then the price of theunderlying moves but your option's value hardly changes? This isprobably because the implied volatility (IV) in your initial purchaseprice settled down. In other words, you paid an inflated price for theoptions thanks to increased demand - and now it has settled back to alevel more in keeping with normal stock option pricing models.

Alwayscheck the Implied Volatilityin the options price and compare it with the Historical Volatility of the underlying asset (stock, commodity, currency) before buying an option.

If you're holding long (bought) option positions, you need tokeep an eye on the delta but more so the theta (time decay). Time decayis the element that eats away at options positions where the priceaction of the underlying doesn't move much.

Option trading strategiessuch as straddles and strangles are particularly vulnerable to this, soalways check the option's theta number before executing these type oftrades.

But if you're into range trading strategies such as iron condors and calendar spreads, or short weighted positions such as credit spreads, the theta time decayworks in your favor. It then becomes simply a matter of how long youhold the position before you exit with a profit - providing the price ofthe stock remains away from your short position.

**************** ****************

Return toStock Option TradingContents Page

Go toOption TradingHomepage