The Bottom Line Options can be used in a wide variety of strategies, from conservative to high risk. Key Takeaways Options are derivative contracts the right, but not the obligation, to buy for a call option or sell for a put option some asset at a pre-determined price on or before the contract expires. Options can be used for directional strategies or to hedge against certain risks in the market.
Pricing an option relies on complex mathematical formulas, but the direct inputs into an option's price include the price of the underlying asset, the option's strike, time to expiration, interest rates, and implied volatility.
Factors That Determine Option Pricing
Once a stock trader becomes good at predicting the future price movement. Options traders must deal with three shifting parameters that affect the price: the price of the underlying security, time and volatility.
Option pricing theory uses variables stock price, exercise price, volatility, interest rate, time to expiration to theoretically value an option.
When the stock price goes up, calls should gain in value because you are able to buy the underlying asset at a lower price than where the market is, and puts should decrease.
Likewise, put options should increase in value and calls should drop as the stock price falls, as the put holder gives the right to sell stock at prices above the falling market price.
That pre-determined price at which to buy or sell is called the option's strike price or exercise price. Interest Rates Like most other financial assets, options prices are influenced by prevailing interest rates, and are impacted by interest rate changes.
- The strike price may be set by reference to the spot price market price of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or at a premium.
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Call option and put option premiums are impacted inversely as interest rates change: calls benefit from rising rates while puts lose value.
The opposite is true when interest rates fall. Volatility The effect of volatility on an option's price is the hardest concept for beginners to understand.
It is called implied volatility IV because it allows traders to determine what they think future volatility is likely to be. Traders use IV to gauge if options are cheap or expensive.
As a result, time value is often referred to as an option's extrinsic value since time value is the amount by which the price of an option exceeds the intrinsic value. Time value is essentially the risk premium the option seller requires to provide the option buyer the right to buy or sell the stock up to the date the option expires. Typically, stocks with high volatility have a higher probability for the option to be profitable or in-the-money by expiry. As a result, the time value—as a component of the option's premium—is typically higher to compensate for the increased chance that the stock's price could move beyond the strike price and expire in-the-money. For stocks that are not expected to move much, the option's time value will be relatively low.
You may hear option traders say that premium levels are high or that premium levels are low. What they really mean is that the current IV is high or low.
- Understanding How Options Are Priced
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The Bottom Line Options are complex, but their price can be described by just a handful of variables, most of which are known in advance. Only the volatility of the underlying asset remains a matter of estimation.
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