What Factors Go Into Option Pricing?

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When describing basic option strategy to newcomers, the general tendency is to describe calls and puts this way: a call is a bet that the stock will go up and a put is a bet that the stock will go down.

This is true in a very basic way. If an investor buys a call on an underlying asset at a particular strike price, they are looking to make money by having the asset rise above that price. An upward move in the price of the asset should increase the value of the call (and vice versa for a put).

However, the options market is more complicated than that. This stems from the fact that an option involves more than a bet on an asset's direction. There are other factors involved.

Options professionals use complicated equations to figure out the theoretical price an option should have.

Here are some basic things that go into option pricing:

1. Price of the Underlying Asset - This is the starting point. An option is only as valuable as how it relates to the underlying asset.

2. Strike Price - The price that defines the option's contract to buy or sell. The value of the option is related to the distance between the strike price and the actual price of the underlying asset. For a call, the higher the asset price above the strike price, the more valuable it will be.

3. Time Until Expiration - An option has an expiration date. After that date, the option has no value, whatever the price of the underlying asset - like holding an unused World Series ticket in December. The closer the option gets to expiration, the more the potential value of that option will erode, until it reaches the base intrinsic value.

4. Volatility - This is a big one and the one that beginners in options trading often need to learn more about.

The price of an option includes what's called a "volatility premium" based on the amount the underlying asset tends to fluctuate over time. Some assets have a greater propensity for wider price movements than others (think speculative tech stocks vs. utilities). This assumed volatility is baked into the price of the option.

The relationship between implied volatility and the price of an option is called "Vega." The higher the value of Vega, the more the price of an option will respond to changes in implied volatility.

Rising implied volatility adds to the value of an option. However, if implied volatility falls, it will weigh on the value of the option, regardless of what the actual price of the asset is doing.

5. Interest Rates - Interest rates are also baked into the price of an option. In terms of owning a call, a decline in interest rates could hurt the price of the option. The opposite is true for puts. A decline in interest rates would benefit the price of puts. As with vega and implied volatility, there's also a Greek letter that describes the relationship between interest rates and an option's price. That's called "Rho." Rho measures how much an options price will change as interest rates change.

6. Dividends - Future dividends that can be paid on the underlying stock greatly affect options pricing. When dividends go ex-div, the amount of the dividend is subtracted from the stock price. Any trader who sells call options will have to pay out those dividends to option buyers. Stocks that have dividends will see a slight decrease in call option premium and a slight increase in put option premium.

Learn More

To learn more about Options Pricing and the basic components of Options Trading, visit https://marketchameleon.com and our Educational page at https://marketchameleon.com/Learn/Introduction/