A Beginners Guide to Options Pricing
Understanding how options are priced is an important part of option trading. Regardless of the way a trader may use options, whether they are used to hedge against losses or to gain from market volatility, profit or loss may depend on the price of the options. Therefore, it is essential to grasp an appreciation of the factors that drive how options are priced to maximise profit and limit loss. This article aims to present a simplified summary of the elements that influence option pricing.
The most commonly used method, and possibly the simplest, to price an option is to use the Black-Scholes Model derived by Fischer Black and Myron Scholes in 1973. The model considers five factors to calculate the theoretical price of an option:
• Strike Price
• Time Factor
• Current Stock Price
• Interest Rate
Remembering that options are a contract that allows a trader to purchase or sell stock, the strike price determines the price at which the stock can be purchased or sold for. The strike price, or exercise price, is a key driver to the price of an option, as profit is realized when a stock can be purchased for less, or sold for more, than the current market price. For example, suppose FMG is trading at a record low of $5. A call option (right to buy) with a strike price at $1 is worth more than a call option at $4. Why? Because exercising the option to purchase FMG stock at $1, when the stock is trading for $5, represents greater value than purchasing FMG at $4. Therefore, the deeper the option is 'in-the-money' (more on this later) the more expensive the option will be.
The time factor, or time value, of the contract can greatly impact the price of an option. A longer period of time before expiration means a higher chance/probability the stock will move in the desired direction which results in higher option price. It is also worth noting that as an option approaches expiration, the price of the option will decrease exponentially.
Current Stock Price
The current stock price, together with the strike price, determines whether an option is 'in-the-money'. 'In-the-money' is a situation where if the option were to be exercise, there would be a financial gain. This occurs when the current stock price is above the strike price for a call option, or below the strike price for a put option. Using the FMG example again, an option is 'out-of-the-money' if the stock is trading for $5, and the call option has a strike price of $7 - there is no gain, if this option were to be exercised. The degree to how valuable an option is, depends how much gain it can deliver if were to be exercised, which is why the current stock price factors into the price of the option.
Interest rates play a smaller part when determining the price of an option. When money is tied up in option contracts, it is away from the bank and not earning interest. The way interest rates move affect the price of an option inversely; as interests rates move up, it becomes less attractive to have money tied up in options, so the option price goes down and vice versa.
Volatility is the most important factor when it comes to option pricing but can be difficult to understand and therefore overlooked. Volatility can be described as how prone a stock price fluctuates in a short period of time. Stocks with high volatility tend to have erratic movements in their stock price whereas stock with low volatility has more stable growth or decline in stock price. For example, if a stock were to swing from $1 to $50 and then back to $5 in six weeks, it would be considered a high volatility stock. However, few would consider a stock volatile if it climbed steadily from $1 to $50 over a 20-year period.
There are many types of volatility, but they drive the price of an option the same way: higher volatility means a greater probability an option will expire 'in-the-money' which leads to a higher option price. Using an example, suppose a trader has a call option for FMG with a strike price at $7 and FMG is currently trading at $5. If FMG has low volatility, it is unlikely that FMG will move to $7 the period of time before the contact expires.
Understanding the factors that influence how options are priced can be the difference between winning and losing trades. Without knowledge of option pricing, traders may expose themselves to over-priced contracts, which can shorten the career of any trader. The strike price, time factor, current stock price, interest rate and volatility work together to determine the price of an option contract, and should be monitored for successful long term option trading.