Learn how options are priced
How are Options Priced?
The market forces affecting the value of the underlying asset will in turn affect the market value of the options attached to those assets. The option itself has no underlying value, its value is derived from the value of the asset itself and your ability to buy or sell that asset.
- Understanding Options premium is key to options trading.
- There are two fundamental components of an option price. These components are intrinsic value and time value.
- Option Price = Intrinsic Value + Time Value
What is Intrinsic Value?
Intrinsic value is determined by the difference in the market price of the underlying stock and the price at which the option can be exercised (the strike price). It is its real value associated with being able to convert into stock.
If you own an option to buy stock XYZ Plc at 400 (a call) and the current market price of the stock is 420, then you would expect that your option would be worth 20. The intrinsic value of the option arises because the option gives you the right to buy the stock at 20 less than the current market value of the stock.
In regard to a put, if you bought the 400 put option in XYZ Plc and the market is trading at 375 then the option has an intrinsic value of 25.
Options that have intrinsic value in their pricing are referred to as being ‘in-the-money’. For call options, this means that the strike price of the option is below the current market value of the underlying asset and so there is value in exercising the option. The intrinsic value is present as the option holder can exercise their option and buy the underlying shares for a price lower than they could in the market.
The calculation of intrinsic value for put options is the same as for call options, except that intrinsic value for put option prices is present when the strike price of the option is above the current market value of the underlying asset.
Options that have no intrinsic value in their pricing are referred to as being ‘out-of-the-money’. For call options, this means that the strike price is above the current market value and so there is no value in exercising the option.
As the name suggests, an at-the-money option is an option whereby the strike price of the option is equal to the current market value of the underlying shares. The option premium has no intrinsic value but will have time value.
Time value is a little more difficult to understand than intrinsic value. The time value of an option is the value over and above the intrinsic value that the market values on that option. It can be considered as the value of the continuing exposure to the movement of the underlying asset price that the option provides.
Time value in options will vary with in-the-money, out-of-the-money and at-the-money options. This is because each of these scenarios presents different opportunities and possibilities of an increase in the intrinsic value of an option. Generally, time value is greatest on at-the-money options, as the risk for the seller is highest here that it could go in your direction.
Time Value is influenced by the following factors;
Time to expiry:
The first factor affecting the time value of an option is time itself. The more time you have in which to achieve the market movement you expect, the greater the chance is of it happening so, the longer the time period left on an option, the greater the time value will be.
As the expiry of the option gets closer, the time value diminishes with every day that passes. Time value also does not reduce at a constant rate, it reduces at a faster rate the closer you get to the expiry date.
Volatility is the range and speed at which a price moves. When a price moves a lot within a relatively short amount of time, it is said to have high volatility. The greater the volatility of the underlying asset, the greater the time value of the option that will exist.
When trading options, it is the ex-dividend date that is important. The ex-dividend date is the day on which all shareholders who own shares at the end of trade on that day will be entitled to the dividend payment. The next day, the share price usually falls by an amount similar to the dividend amount, as anyone who buys shares on that day will not be entitled to the dividend.
Options do not grant you any rights to dividends in the underlying shares. When choosing an option, you should always consider any dividends payable. If the underlying share has an ex-dividend date during the life of your option, this will affect the intrinsic value of the option, without the option holder having any rights to any dividends. Any ex-dividend amounts will be priced into the intrinsic value.
Many forces act on the price of options which can be seen below;