Article / 06 February 2018 at 13:30 GMT

How option pricing works: a timely refresher

Director, Europe / The Options Industry Council (OIC)
United Kingdom
  • The Black-Scholes formula was the first widely used model for option pricing
  • A call option is in the money if the stock price is above the exercise price
  • But a put option is in the money if the stock price is below the exercise price
  • An option's fair value is an informed guess, as volatility cannot be predicted 
By Gary Delany

We talk a lot about an option's price, but do we know the basic components that can help us to estimate an option's price? A quick refresher may be useful.

Although it is not the only option pricing model, the Black-Scholes formula (1973) was the first widely used model for option pricing. You can use this formula to calculate theoretical option value using the key factors listed below. While the Black-Scholes model does not perfectly describe real-world options markets, it is still often used in the valuation and trading of options.

Black and Scholes list the key determinants of an option's price as follows:

  1. The price of the underlying stock
  2. The exercise (or strike) price of the option
  3. Time until expiration
  4. Expected volatility
  5. Current risk-free interest rate
  6. Dividends

nnn

Volatility, a measure of risk or uncertainty, is hard to predict. Photo: Shutterstock

Intrinsic value and time value

The relationship between the first two components of an option's price, the price of the underlying stock and the exercise price, determines the intrinsic value of the option, which can be seen as the in-the-money portion of the option premium, or the value of the option if it is exercised now.

A call option is in-the-money if the stock price is above the exercise price. A put option is in-the-money if the stock price is below the exercise price. Out-of-the-money and at-the-money puts and calls have intrinsic value of zero (that is,. they will have no value if exercised), but may still have some 'time value' as they may move into-the-money during the lifetime of the option.

Most options apart from those very close to expiry have so-called time value. In-the money options will have intrinsic value and also time value; out-of-the-money and at-the-money options will only have time value.

Call options
Source: Gary Delany
 
Other influences being unchanged, as the value of the underlying stock rises, a call will generally become rise in value, whereas a put will become less valuable. A decrease in the value of the underlying stock will generally have the opposite effect - the call's value will fall and that of the put will rise.

Intrinsic and time value
Source: Gary Delany

Time until expiry

The time until expiration, when the option will cease to exist, also effects the time value component of an option's premium. Generally, as expiration approaches, the level of an option's time value decay for both puts and calls.

This effect is most noticeable with at-the-money options. Note that time value typically decays more steeply as expiration approaches.

Time decay
Source: Gary Delany

Volatility

This is probably the most discussed of the option valuation variables, because it is the most difficult to measure. Volatility is not the trend of a stock's price, but the level of fluctuation in it.

Volatility
Source: Gary Delany

Volatility is a measure of risk (uncertainty), or variability of price of an option's underlying security. Higher volatility estimates indicate greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike. It is most noticeable with at-the-money options.

Volatility is hard to predict. Looking in the past, it is comparatively easy to calculate historical volatility. But, just as is the case with the underlying stock, historical performance is no guide to what may happen in the future.

Interest rates

Interest rates are historically low at the moment, but this was not always the case. Interest rates determine the cost of carry, the potential interest paid for margin or received from alternative investments (such as a Treasury bill). When interest rates are higher, their influence on an option's price is greater.

Dividends

Dividends are paid to registered holders of stock, not the holder of, say, a call option. Option pricing takes into account an option's hedged value, so ordinary dividends from stock are a factor when calculating the option's price.

After a dividend has been paid, a stock's price will fall. The ex-dividend date (ex-date) is the date on which the price reduction takes place. Investors who own the underlying stock (not those holding an option) on the ex-date will receive the dividend.

The real world

These calculations give you an estimated value or 'fair value', which will then be influenced by supply and demand in the market, so the values quoted in the market will differ from the calculated price. An option's fair value is at best an informed guess, as volatility cannot be predicted and only calculated historically.

Market influences can actually result in highly unexpected price behaviour during the life of a given options contract. No model can reliably predict what options premiums will be available in the future, but investors can use pricing models to anticipate an option's premium under certain anticipated circumstances.

For instance, you can calculate how an option might react to an interest rate increase or a dividend distribution to help you better predict the outcomes of your options strategies.

Why option pricing models matter

A grasp of the essentials of option pricing is useful to any option investor. Option pricing also generates the "Greeks", the measures that tell you the sensitivity of any option to changes in price (delta), volatility (vega), time (theta), and interest rates (rho).

Option prices don't hinge on just one variable. Option users should have an awareness of what can go right and what can go wrong. For example, if volatility moves sharply higher, that will make puts and calls worth more if none of the other variables have changed. Or an investor could adjust the quantities of a potential spread position and see how that change would affect the delta, gamma, and other Greeks.

Modelling tools

You can find a free option price calculator. on the OIC website.

As well as being fun, using the calculator helps you understand what impact the various inputs have on an option's price. This tool shows how adjusting, for example volatility, expiration date or the underlying price can impact an option. 

OIC
Source: Gary Delany

— Edited by Robert Ryan

Gary Delany is European director of the Options Industry Council.

You can find more information on option pricing at the OIC website, and also sign up for a short course on option pricing, all free of charge.

The Options Industry Council (OIC) and Saxo Bank
The Options Industry Council (OIC) and Saxo Bank have both invested heavily in their online education initiatives, which enable investors to increase their option knowledge and skills using easily accessible and easily digested content. For OIC's comprehensive website go to www.OptionsEducation.org and follow us:
(Add 6 Social Media tags here)
Saxo Bank's educational material can be found at https://www.home.saxo/education

About The Options Industry Council (OIC)

Celebrating its 25th anniversary, OIC is an industry resource managed and funded by OCC, the world's largest equity derivatives clearing organization. Its mission is to provide free and unbiased education to investors and financial advisors about the benefits and risks of exchange-listed equity options. OIC offers education which includes webinars, podcasts, videos, seminars, self-directed online courses, mobile tools, and live help. OIC's Roundtable is the independent governing body of the Council and is comprised of representatives from the exchanges, member brokerage firms and OCC. For more information on the educational services OIC provides for investors, visit www.OptionsEducation.org.

Disclaimer:
Options involve risk and are not suitable for all investors. Individuals should not enter into Options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, which may be obtained from your broker, from any exchange on which options are traded or by visiting www.OptionsEducation.org. None of the information in this post should be construed as a recommendation to buy or sell a security or to provide investment advice. ©2018 The Options Industry Council. All rights reserved.


Disclaimer

The Saxo Bank Group entities each provide execution-only service and access to Tradingfloor.com permitting a person to view and/or use content available on or via the website is not intended to and does not change or expand on this. Such access and use are at all times subject to (i) The Terms of Use; (ii) Full Disclaimer; (iii) The Risk Warning; (iv) the Rules of Engagement and (v) Notices applying to Tradingfloor.com and/or its content in addition (where relevant) to the terms governing the use of hyperlinks on the website of a member of the Saxo Bank Group by which access to Tradingfloor.com is gained. Such content is therefore provided as no more than information. In particular no advice is intended to be provided or to be relied on as provided nor endorsed by any Saxo Bank Group entity; nor is it to be construed as solicitation or an incentive provided to subscribe for or sell or purchase any financial instrument. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. As such no Saxo Bank Group entity will have or be liable for any losses that you may sustain as a result of any investment decision made in reliance on information which is available on Tradingfloor.com or as a result of the use of the Tradingfloor.com. Orders given and trades effected are deemed intended to be given or effected for the account of the customer with the Saxo Bank Group entity operating in the jurisdiction in which the customer resides and/or with whom the customer opened and maintains his/her trading account. When trading through Tradingfloor.com your contracting Saxo Bank Group entity will be the counterparty to any trading entered into by you. Tradingfloor.com does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of ourtrading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. To the extent that any content is construed as investment research, you must note and accept that the content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication under relevant laws. Please read our disclaimers:
- Notification on Non-Independent Invetment Research
- Full disclaimer
- 沪ICP备13028953号-1

Check your inbox for a mail from us to fully activate your profile. No mail? Have us re-send your verification mail