Options Pricing Explained
When you use options in trading, you will need to figure out what the instruments are worth to you. Ultimately the prices will be decided in the marketplace, which is essentially an open auction where you will have to out-bid any other buyers or match any other offers if you want the right to buy or sell the security at the strike price you have in mind. So what should the option be worth to you? It’s important you think about all the factors involved in options pricing, because you can bet everyone else will be, and you don’t want to lose money on your position without understanding why. In a nutshell, there are six major factors which influence options premiums:
1. Changes in the price of the underlying security.
An option is just a derivative, just a nebulous sort of possibility of what may happen… that is, until it’s in-the-money. Then it can be exercised and effectively redeemed for the security itself, and therefore it gains intrinsic value. So a call has intrinsic value if the underlying security is currently priced higher than the call’s own strike price (it’s in-the-money), and that intrinsic value is equal to the positive difference between the underlying security’s price and the strike price of the call. A put option is the opposite: it is in-the-money and has intrinsic value when the market is lower than the strike price. When these options are in-the-money, their value will change penny for penny as the underlying security changes. When they’re still out-of-the-money, however, their premiums will change at only a fraction of the pace of the underlying security’s changes. § Read the rest of this entry…