Any trader will admit that understanding and, more importantly, mastering the concept of option pricing and its correct value determination is mandatory for successful trading.
The actual price of an option is determinable when you consider all factors that are responsible for its actual price. Let’s take petroleum for instance. Final prices of petroleum are dependent on consumer demand, crude oil price, seasonal changes, local and state taxes and refinery productivity etc. When you buy or sell options and wish to know or calculate its price beforehand, you may resort to a mathematical formula such as the Black Scholes model. You just need to consider the variables the model comprises and you will arrive at the appropriate price.
There are several factors involved in the valuation of options. These are:
1. The Current Price of the Stock: This depends on logical thinking. If a call option interests you and gives you the opportunity to pick up stocks of X company, say, at Rs 390 a share, then most naturally you would be willing to pay in excess for the aforesaid call when the particular stock trades at Rs 390 as against its trading at Rs 400. This is solely because the call option gets much closer to being at an ITM of Rs 49 than it would have been if it traded at Rs 40. Put options, however, work oppositely.
2. The Strike Price : This may be defined as the price payable by the call owner to purchase stock, while a put owner decides to sell his stock. This is similar to the example cited above. One tends to pay more for the right to purchase stock at Rs 380 than Rs 400. The average investor would of course, prefer such rights that enable him to purchase stocks at lower prices at any moment of the day. This makes calls more expensive with the strike price moving downwards. Similarly, puts are more expensive value wise when the strike price spirals.
3. Option Type: The option value depends on its type. There are basically two types: Put or Call. The difference clearly hinges on which side you exactly stand of the market or trade. This is probably the simplest variable comprehensible to the average trader.
4. Period Before Expiry: It needs to be borne in mind that all options come with a definite lifespan and tend to expire on or after a certain date. Therefore, the value of an option increases with additional time. The more time available until expiry, the greater are the chances of making profitable moves.
5. Interest Rates: This is an insignificant factor while ascertaining the option’s price. As interest rates rise, call option values rise too. When the trader opts for the call option as against the stock, then any extra cash in his kitty should earn interest for him, theoretically at least. Of course, this doesn’t happen in real world situations but the basic theory makes sense.
6. Dividends : When the stock trades and yet, its holder gets no dividends, the situation is termed ex-dividend and the price of the stock gets diminished by the amount of dividend payable. With rising dividends, put values increase while call values decrease.
7. Volatility : This is considered to be the big variable. In simpler terms, volatility is the difference recorded in day-to-day stock prices. It is also referred to as swings that affect a stock’s prices. The more volatile stocks are more frequently subject to a varying strike price level as compared to their non-volatile counterparts. With big moves, the chances are higher to make money and the investor shifts out of the Blue sphere. Thus options on volatile stocks are definitely more expensive than the less or non-volatile ones. It is always prudent to remember, therefore, that even the minutest of changes in volatility estimates impact options prices substantially. Volatility is more often viewed as an estimate and using just an estimate and future volatility particularly, makes it virtually impossible to correctly calculate the right option value.