Option Pricing Overview

How is the correct price of an option determined? The question is difficult and becomes even more complicated when option combinations such as spreads are evaluated. The question of option valuation is best answered by considering factors which affect the price of an option.

The next five factors are crucial to determining the price of an option are:

1. Strike price: The more the option is in the money, the more intrinsic value it should have, which will result in a higher price. Options which are in the money are worth at least their intrinsic value less any other opportunity costs, such as interest rates. For calls, the higher the strike price the cheaper the option, for puts, the lower the strike price the cheaper the option.

2. Underlying security price: The reasoning is the same as for the strike price. The underlying future and strike price have a direct impact on the price of an option.

3. Time to expiration: The greater the number of days to expiration the more expensive the option. A future has a greater chance of going into the money with an option which has a longer expiration date, therefore, an option buyer should be willing to pay more for a longer term option. An option writer will incur more risk with longer term options and will consequently need to collect more premium for selling options which have a longer expiration.

4. Volatility: The volatility of the market is one of the most important factors affecting the price of an option. There are many different ways to calculate the volatility of a market. The volatility of a market is a measure of how the price changes on a relative or percentage basis. Mark Markets which are more volatile have a greater chance of reaching a strike price and going into the money. Options in markets with a higher volatility should have bigger premiums than options in less volatile markets. An option seller will want more premium to sell an option in a highly volatile market because the risk is greater. An option buyer should expect to pay more for an option in a market with a higher volatility.

5. Interest rates: In the money options can be a proxy for buying or selling the outright. Certain underlying instruments such as stocks pay dividends, which reduces their carrying cost. This will also affect the pricing of the option.

Of the five variables volatility is the most crucial in evaluating the price of an option. The first three factors-strike price, underlying security price, and time to expiration-are easily known when evaluating an option. The fifth factor-interest rates-can become significant if rates are volatile and make large moves, as in the early 1980s. Interest rates do not generally change so radically and a range can be predicted with a reasonable degree of accuracy. The fourth factor-volatility-can be hard to predict and may change quite rapidly, greatly affecting the price of an option. Furthermore, volatility is measured in various ways by different people, making it more difficult to quantify.