How Are Stock Options Priced?
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Option pricing consist of 2 main components : Intrinsic Value and Premium.
The intrinsic value is simply the value that is already built into the option at the moment that you bought it.
Example: If a stock is currently trading at $50, a Call option with a Strike Price of $40 will have a $10 value already built into it.
Therefore, that option will be priced at $10 + premium. Similarly, if that same stock is currently trading at $50, a Put option with a
Strike Price of $60 will have $10 value already built into it as it allows you to immediately sell that same stock at $60 the moment you bought it.
That option will also be priced at $10 + premium. Such an Option Contract with intrinsic value built into it is known as an In The Money (ITM) Option.
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Conversely, the price of an option will consist only of it's Premium when there is no built in value at the moment you bought it.
Example: If a stock is currently trading at $50, a Call option with a Strike Price of $60 will have no intrinsic value built into it. Similarly,
a Put option on that same stock with a strike price of $40 will have no intrinsic alue built into it. Such an option contract with no intrinsic value built into it is known as an Out of The Money(OTM) Option.
The Option Premium is similar to an insurance premium. A fee that you pay to the seller of the option in order to justify the risk that the
seller is undertaking and the commitment that the seller is bound to due to the option contract that was sold to the buyer.
Option premium is commonly priced in the exchanges using the
Black-Scholes model.
It combines the time remaining until expiration, the strike price, the current price of the underlying and an estimate of future volatility known as the implied volatility (IV) to generate a theoretical price for an option.
Because
implied volatility is the only unknown input, proper options pricing is entirely dependent on accurate forecasts of future volatility. The usual approach is to measure the actual volatility of the underlying over the recent past, adjust for anticipated news events such as an upcoming earnings release, and add some margin for safety. This approach works fairly well for liquid (heavily traded) options.
Options pricing for strike prices a long way from the current price of the underlying is a little trickier. Partly as a reflection of their lower liquidity, and partly as acknowledgment that unexpected large price movements can and do happen, such options have an additional level of margin added to their price.
Options pricing must also account for a few other variables. If the underlying happens to pay dividends, and one is payable prior to expiration, the pricing model must take that into account. Options pricing is also sensitive to interest rates; if the overall economic situation is one where interest rates are likely to move significantly in the near future, adjustments will be necessary.
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