Valuing Options

Introduction

A variety of factors determine the price of an option.

One of the main considerations in the value of an option is the behavior of the underlying stock. Because investors will have varying opinions about how the stock will behave in the future, individual option traders may also disagree about the value of any given option.

In addition, the value of an option is highly dependent on the amount of time left before the option expires. Because options have a limited lifetime, they are considered wasting assets. In other words, their value decreases as their expiration date approaches.

Intrinsic & Time Value

Part of an option's price is composed of intrinsic value. Intrinsic value is how far an option is in-the-money. It is calculated by subtracting the option's strike price from the stock's market price. An out-of-the-money option has an intrinsic value of zero. For example if XYZ is trading at $58 and the June 55 call is trading at $4, to calculate the intrinsic value subtract $55 from 58, leaving you with $3 of intrinsic value. The remaining $1 is known as extrinsic or time value.

Time value, or extrinsic value as it is sometimes called is the amount over intrinsic value that a buyer pays for the option. When buying time value, an options purchaser is buying the possibility that the option will increase in value before it expires. As the option nears expiration its time value decreases toward zero. This will be further explained in the section on theoretical value immediately below.

Theoretical Value

Theoretical value is the objective value of an option as calculated by a standardized formula. It shows how much time-value is in an option. The most commonly used formula is known as the Black-Scholes model. Fischer Black and Myron Scholes realized that options value has similar characteristics to waves and adopted formulas you may have learned in college physics to options valuation.

To calculate the theoretical value of an option, the Black-Scholes model considers the price of the stock, the option's strike price, the time remaining before expiration, the volatility of the underlying stock, the stock's dividends, and the current interest rate.

Although an option may trade for more or less than its theoretical value, the market views theoretical value as the objective standard of an option's value. Because of this, the price of all options will tend toward their theoretical value over time.

The Components of Theoretical Value

Volatility

The volatility of the underlying stock is one of the key factors in determining the value of an option. Often, though not always, as the volatility of a stock increases, so do its options' prices. The difficulty of predicting the behavior of a volatile stock allows the option seller to command a higher price for the additional risk.

There are two types of volatility, historical and implied. Historical volatility is a measurement of the stock's movement based on how it has behaved in the past.

By contrast, implied volatility is calculated using option prices. In other words, implied volatility is a measurement of the stock's movement as implied by how the market is currently pricing options.

Strike Price & Stock Price

The strike price and the stock price are relevant to the formula since the more in-the-money an option is, the more intrinsic value it has. In addition, the more in-the-money an option is, the greater the chance it will finish in-the-money, affecting value to the option premium.

Dividends

Dividends are important since the owner of a call option can always exercise his/her right to the stock and receive any dividend it might pay.

Interest Rate

If you buy an option rather than a stock, you invest less money upfront. For example if you buy the Gro-Grub June 35 calls for $5 you only pay $500 for the right to the stock. If you buy 100 shares of stock for $38 you invested $3,800. You can take the $3,300 that you did not invest in Gro-Grub Foods and invest it elsewhere. If you put it in short -term bonds, then you would earn interest. Since you might pay up to $3299 to save $3,300, the interest savings is calculated in the value of the option.

Days Until Expiration

As explained above, an option is a wasting asset. Since it wastes a little as each day elapses, the amount of days left in its life is used in the calculation of its remaining value.

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Buying Options