Understand the Main Drivers of Options Pricing Before You Start Options Trading
Trading stocks confidently and being successful is good. Experienced traders just not trade stocks but even options. They identify stocks, which indicate big moves soon and take advantage. If you don’t then you are losing on good opportunities.
Explore the simple factors before you learn about different options trading strategies to gain from stock movements.
Prior you step in the trading options world, it is crucial to understand the factors that play a role in determining option value. It includes –
- Existing stock price
- Intrinsic value
- Expiration time
- Interest rates
Some options pricing models make use of these parameters to decide the fair option value. Widely used model is Black-Scholes model. Basically, options are similar to other financial investment and you need to get familiar with the factors to cash in on market movements.
Primary drivers of options pricing
Existing stock price, the intrinsic value, expiration time, and volatility are primary drivers. Existing stock price is practically clear but the up or down price movement has direct impact on option price.
A rise in stock price will increase the call option price and decrease put option price. A fall in stock price will reverse the price of calls and puts.
Strike price will determine, if option has intrinsic value.
- Call options intrinsic value is equal to the underlying assets existing price minus call options strike price
- Put options intrinsic value is equal to put options strike price minus the underlying stocks existing price.
Options intrinsic value reflects the efficient financial advantage, which can be obtained from instant action. It is minimum value of an option. Out of the money or at the money has no intrinsic value.
Time value until expiration
Options with long expiry date have the chances of ending up profitable or in the money. With approach near expiry date options time value starts to drop. In general, 1/3rd of time value gets lost in first half and 2/3rd in the second half.
Time value is equal to the difference between option price and intrinsic value. The closer securities get to expiration the more volatility is needed to affect option price. Time value is also called extrinsic value.
Volatility are of different kinds but implied and historical are most popular. Investors check the past volatility, so it is termed as historical or statistical volatility. It helps traders to decide the possible extent of underlying stocks future moves.
Implied volatility is prediction of future volatility. It is an indicator of existing market sentiment. Even though implied volatility is hard to measure, option premiums can be clearly evaluated. If underlying asset shows high volatility then high price fluctuations will be expected, so option premiums will be high.
Interest rates affect option prices in a small but measurable way. If interest rates increase the call premiums will increase and vice versa in put premiums. Buyer will need to bear the interest costs if cash is borrowed or existing fund is used to purchase shares.
If underlying stocks dividend raises, the call price decreases and put price increases. The result is reverse if underlying stocks dividend drops down.
Know these drive factors and gain from the price moves!