How Options Are Priced
When dealing with stock options, there are a number of different ways in which these investments may be priced. In particular, the price of an option is essentially based on six different pieces of data. These include:
• The price of the underlying shares of stock. For example, if the price of the underlying stock begins to rise, a call option will become more valuable and its price will rise as well.
• The volatility of the underlying stock. If, for example, the underlying stock has wild price swings in either an upward or downward fashion, then the option will be more expensive to purchase.
• The option's strike price. The strike price of an option will be included in its overall price calculation. For example, if the strike price of a call option goes up, then the price of the option will actually go down.
• The options expiration date. Expiration date is a major factor is the pricing of the option. This is because as the expiration date gets closer, the value of the option will drop.
• Dividends and interest rates. Typically, the higher that interest rates rise, the higher the option premium will normally go up as well.
• Supply and demand. Just like with many other items for sale, an option can actually be affected by how many investors are buying or selling at any given time. For example, if there is a large number of investors who are purchasing a particular option, the price of that option will rise – even if the price of the underlying stock is not moving in either direction.
Options also have intrinsic and extrinsic value that can affect their pricing as well. Intrinsic value, for instance, is simply the value that is already built into the option at the moment it was purchased by an investor. For example, if a stock is currently trading at $40 per share, then a call option with a strike price of $30 will have a $10 value built into it. This is because the call option allows the investor to buy a $40 stock at $30.
Extrinsic value, also referred to as the premium value of the time value, is the part of an option's price that is determined by factors other than the price of the underlying asset. This is what the investor is actually paying the seller of that option for the risk that the option seller is taking on for selling the investor the option contract. Note that the price of an option contains only its extrinsic value when there is not built in value at the moment it was purchased by the investor.
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