To value options investors must understand the role of options and how the market works. This article will break down the different factors that help investors value stock options.
When you buy or sell options, there is a market – a system by which market markets name a price (bid) they are willing to pay for any option you want to sell. In addition, they name a price (ask) at which they are willing to sell any option you want to buy.
These bid and ask prices are not chosen at random. They are values based on a mathematical formula, such as the Black-Scholes model. To that model, market makers may decide to add tweaks of their own that depend on the current risk (or lack thereof) of their positions.
The point is that these prices are not chosen at random. The value of an option can be calculated exactly if you know the true number for each of the seven items that go into the equation. In reality, only six of these ways to value options are known, and the seventh (volatility) must be estimated. Volatility plays such an important role in determining the value of an option, that it’s impossible to calculate an options true value. The best anyone can do is to estimate that volatility, which in turn produces an estimated value for the option. And the difficulty of making that estimate is that it’s the future volatility that is used in the model. Specifically the time period is between when the option is traded and expiration.
Ways to Value Options
1. Stock price – Consider a call option. If you want to own an option that gives you the right to buy stock at $50 per share, surely you would pay more for that call if the stock is trading at 49 than when it is trading at $40. The higher the stock price the more a call option is worth. Similarly, the lower the stock price, the more a put option is worth. If you want to have the right to sell stock at $30, you would pay more for that put option when the stock is $29 than when it is $35. The lower the call stock price, the more a put is worth.
2.Strike Price – The price at which the call owner may buy, and the put owner may sell, stock. You would pay more for the right to buy stock at $60 than for the right to pay $70. Thus, calls increase in value as the strike price moves lower. And puts increase in value as the strike price increases (the right to sell at $45 is more valuable than the right to sell at $40)
3. Type of option (there are only two types) – An option’s value depends on whether it is a put or a call.
4. Time before expiration arrives – The more time, the more an option is worth. As the option owner, you want the stock to undergo a favorable move. The more time, the greater the possibility of that favorable move occurring.
5. Interest rates – This is a minor factor in the price of an option. As interest rates rise, call options increase in value. When investors buy calls instead of stock, they have extra cash (not used to buy stock) and that cash can earn interest. When rates are higher, they earn more interest, and thus, are willing to pay more to own call options.
6. Dividends – When a stock goes ex-dividend (trades without the stockholder receiving that dividend), the stock price declines by the amount of that dividend. Thus, call are worth less, and puts are worth more, as the dividend increases.
7. Volatility – Volatility is a measure of how much the stock prices varies from day to day. In other words, it’s a measure of how much the stock price is likely to change over time. Volatile stocks undergo larger and more frequent price changes than non-volatile stocks. Because the option owner is hoping for a big price change, the value of an option on a volatile stock is much greater than the option on a less volatile stock. A small change in the volatility estimate can have a significant impact on the price of an option.
Further Reading, Options Trading: