Understanding Options Pricing

There are three major factors that affect the price of an option:

1. Strike price;
2. Volatility of the underlying security.
3. Time value;

Options Strike price

The strike price is the price at which an option can be exercised. Using the example of a stock index option, it is the index value at which an buyer can buy or sell shares of the underlying stock index. An option's intrinsic value is defined as the difference between the market price of the underlying security and the strike price of the option.

A call option has an intrinsic value if its strike price is lower than the current market price of the underlying security. In this case, the option is said to be "in-the-money". Conversely, if the market price of the underlying security is below the strike price of the call option, the option is considered "out-of-the-money". Finally, if the current market price of the underlying security is equal to the strike price of the call option, the option is said to be "at-the-money".

The reverse is true for put options. A put option is "in-the-money" (has intrinsic value) if its strike price is higher than the market price of the underlying security. It is "out-of-the-money" if its strike price is lower than the market price of the underlying security. Finally, if market and strike prices are equal, the put is said to be "at-the money".

In-the-money options are always are more expensive than out-of-the-money options, because the risk of losing the option premium is higher for out-of-the-money options. The higher an option's intrinsic value, the higher its price, because a higher price means lower risk for the buyer.

Options Volatility.

Volatility is defined as the degree to which an underlying security moves (up or down) over a period of time. The volatility risk of an options portfolio thus accounts for the unpredictable changes that may occur in the underlying asset during the life of the option.

Volatility measures the rate of (price) change of an underlying instrument. The higher that volatility, the more likely it is that an option will become profitable before it expires. That is why volatility is a primary determinant of options valuation.

Options Time Value

Time value - is one of the major components affecting an option's current price). Time value is more difficult to determine than intrinsic value. Time value derives from the buyer's willingness to pay a premium for a possible future increase in the value of an underlying security within the time period leading up to the option's expiration.. If the underlying security does indeed increase in value before the option expires, the (call) option will become more highly valued.

Basically, the more time that remains until an option expires, the higher its time value. But the buyer of an option must also pay a greater price for a higher time value, because the seller of the option takes on a higher degree of risk - the more time is left until expiration, the more an option can (theoretically) go in-the-money, which drives up its market value .

Volatility and time value have a tremendous impact on the price of an option. For an options buyer, time is the enemy that increasingly erodes the value of an option and increases the risk of losing the entire premium.