Pricing of Options
We all know that stock options are bought and sold in the stock market for a particular price. This price has been called the premium or a stock option’s selling price. But have you ever wondered how a stock option’s price comes about? I mean, who determines them and what possible factors could affect a stock option’s price? To answer these questions and help you understand more of pricing options, I have prepared a short discussion on stock option prices and the factors that determine them.
There is actually no one person, thing, circumstance or group of persons that singly affect the price of a stock option. There are several factors that affect a stock option’s price. The most important of these factors include the price of the stock in which the stock option’s value is derived from, the period before expiration, dividends or earnings per share (EPS), the volatility of the underlying stock price as well as interest rates.
Intrinsic Value
It is not hard to understand why the underlying stock’s price is one of the major if not the most important factor that drives stock option prices. They are after all, the reason why investors buy stock options. A call option is said to be in-the-money if the price of the underlying stock is above the strike price, or the price in which the call option can be exercised. A put option is in-the-money if the price of the underlying stock is below the put strike price. If you subtract the price of the underlying stock with the strike price then you get a stock option’s intrinsic value. If the strike price and price of the stock is equal then the stock option is said to be at-the-money whereas a stock option that is neither in-the-money nor at-the-money is said to be out-of-the-money. Out-of-the-money and at-the-money stock options have no intrinsic value and have only a purely time value. Those stock options that have intrinsic value consider the amount that exceeds the intrinsic value as the time value. Time value includes the time left before the arrival of the expiration period, volatility of the stock, dividends, and interest rates. If you think about it then, the total option premium is determined merely by the total of the intrinsic value and time value of the underlying stock.
Time Value
Part of the time value is the time left until a stock option expires. This is an important factor because the farther away the expiration period, the more opportunity the stock price will appreciate or depreciate. This so called ‘time element’ loses value as the expiration date grows near. Volatility of the stock price is also considered an important element in determining a stock option’s price because the more volatile the stock price is, the greater the chances that the stock price will move to become favorable to the holder. Volatility means the likelihood that an underlying stock price would increase or decrease. This means that the greater volatility, the higher the stock option’s premium.
The amount of cash dividends or EPS that a stockholder gets is also a factor in determining a stock option’s price. It has been observed that the higher the cash dividends the lower the call option prices and the higher the put option prices. Interest rates affect stock options too as the higher the interest rates, the higher the call option prices go and the lower the put options are.