Options

# Options Pricing: The Basic Factors You Should Know

Anyone who has studied options knows that there are six basic factors that make up the price of an option.  They are, the price of the underlying, strike price, days until expiration, dividends, interest rate and volatility.  I thought this might be a good time to review all of these factors and how they influence an individual options price. I am choosing to do this review in more of a straight forward way rather then a purely mathematical way.  There are many excellent books that use great mathematical models in explaining options, but I believe that for terms of a review we can look at some real life examples and learn from those situations.  The purpose of this review is to help you to make better decisions on which options to purchase and which ones to write.

The first two factors of the underlying price and the strike price are both the easiest to illustrate and to understand.  I will use General Electric (GE) stock for example purposes.  When GE stock is trading at \$36, then it is evident that the 35 Call is intrinsically worth \$1 and the Put has no value at all, whereas the 40 Call has no value and the 40 Put is intrinsically worth \$4.  Should GE have a rally and trade \$39 the 35 Call is worth \$4, the 35 Put still has no value.  The 40 Call is still worthless and the 40 Put is now only worth \$1. This example shows very quickly how the underlying price will quickly influence the price of the options.  As you can also see the Strike Price that is chosen also will have a direct effect on the pricing of the option.

The concept of days until expiration having an effect on the pricing of options is really one of common sense as much as anything else.  When looking at two time frames the longer term one will hold a higher price as a greater time is equal to greater risk. Even if we ignore the interest rate component of things for a moment and go back to our GE example this is easily illustrated.   Using a date of August 15, if GE is trading at \$37 and we are looking at buying the September 40 call or the December 40 call the December 40 call is going to cost more as there is a greater risk to the Call writer that the Dec 40 Call is going to finish in the money.  The call buyer gets to participate in three more months of movement and potential profits.

Dividends are sometimes easily overlooked as a factor but they are something that should be thoroughly researched before trading an option. Although past dates of dividends and the amount paid are easily found, companies do sometimes change both the date and amount of the dividends so this is something which one should always keep reviewing.  There are many different scenarios here so we will say that one should realize that if GE pays a \$1 dividend annually, and they go ex-dividend quarterly that the stock is going to lose a quarter on those days.  This means that there has to be an extra \$.25 built in to the deep puts so that they can be in line with the stock on ex-dividend date.

Interest rates are something that has been in the news lately with the actions of the Federal Reserve, and they are one of the factors in pricing options.  The quickest and most common sense to look at how rates influence pricing is this,  as interest rates increase it becomes more attractive to own calls as they are a cheaper alternative to carrying the stock.  Using the case of GE trading at \$36, it would be much cheaper to buy a GE 30 Call for \$6 and carry that then it is to pay the carrying cost on stock.  As an investor one has to figure if it will be cheaper to pay the extra premium above \$6 that will be necessary as you go out in time or if it is cheaper to carry the stock outright.

The final factor in options pricing and the one that is certainly the hardest to understand is the concept of volatility.  By definition volatility is expressed mathematically as an annualized standard deviation of returns.   Volatility is so difficult because you can only look at it in the past and the past volatility in options is not necessarily a good way to predict the future volatility.  Although volatility may often trend one way or another, world events (such as a plane crash) as well as internal company events (bad earnings) can send a companies volatility soaring in a matter of minutes.  Then there are other times when a stock is in a tight trading range for a matter of months and the volatility comes in some every day.  An example of this would be if GE stayed in a trading range of \$34 to \$36 for 6 months you would see the options from all time horizons being affected.  The short term all the way to 3 years out would be significantly cheaper after those 6 months them they were earlier as you could see volatility in 4 to 6 points.  There are many web sites from which you can follow implied volatilities of options, which makes it much easier to make good decisions.

As you go forward trading options these factors are good to keep reviewing so that you can see how the options you trade are moving because of them.  You will be a much better trader if you realize that a company increasing their dividend is going to increase the price of a deep Put.  Knowing the reasons that options move will give you an edge on every trade and hopefully lead you to greater profitability.

##### Joseph G. Kinahan

Joe Kinahan has been an [[option]]s [[market maker]] for 19 years.  He first traded independantly on the floor of the [[Chicago Board Options Exchange]] and then joined ING in 1997.  He then was a Vice President at Saen Options and Managing Director for Van der Moolen.  He is currently with Welllington Capital Group.  Joe has primarily trade [[index|indices]] in Chicago ([[OEX]], [[SPX]] and [[DJX]]).  He has also traded in some equities including Cisco, Oracle and GE.  He has vast experience trading both on and off the floor.  He holds his Masters Degree in Financial Markets and Trading from Illinois Institute of Technology and is currently trading in the [[OEX]] at the [[CBOE]].

Joe Kinahan has been an [[option]]s [[market maker]] for 19 years.  He first traded independantly on the floor of the [[Chicago Board Options Exchang...

##### Senior member
This introductory article discusses the key elements which combine to determine an option's price.

#### Tomerep

##### Member
Well written article, though it is short, it explains the basics of options.

#### charliechan

##### Experienced member
nothing ground breaking here that i couldnt get from any basic standard options text on the net.

#### TWI

##### Senior member
Thanks for the article . With 19 years in market however I was hoping to read a little more than this encyclopedia definition. Is this a work in progress?

#### Robertral

##### Well-known member
twalker said:
Thanks for the article . With 19 years in market however I was hoping to read a little more than this encyclopedia definition. Is this a work in progress?

Anyone who is interested in reading the basics of option pricing should buy "Futures, Options and other Derivatives" by Hull.....It's a great book....I wouldn't read second hand information from a net article on a Forum like this.

##### Senior member
twalker said:
Thanks for the article . With 19 years in market however I was hoping to read a little more than this encyclopedia definition. Is this a work in progress?

Since we have members of all levels of experience, we have to take that in to account when posting articles. This particular one is quite basic, as you've noted, and thus intended for less knowledgable folks.

##### Senior member
Robertral said:
Anyone who is interested in reading the basics of option pricing should buy "Futures, Options and other Derivatives" by Hull.....It's a great book....I wouldn't read second hand information from a net article on a Forum like this.

Not sure I'd call it "a great book" myself. It's thorough, to be sure, but a rather tedious read if I remember correctly.

#### Interactive Brokers

##### Well-known member
I find this article interesting for those starting out in options. That is, it is clear, to the point and inciteful.

#### blackcab

##### Established member
Interactive Brokers said:
I find this article interesting for those starting out in options. That is, it is clear, to the point and inciteful.
That's illegal these days isn't it?

#### grantx

##### Senior member
Rhody,

Unfortunately, most of the bestsellers re the markets are not much better than sexy fantasy . At least you won't go broke (as quickly) reading Hull.

Grant.

#### neil

##### Legendary member
excitement

Interactive Brokers said:
I find this article interesting for those starting out in options. That is, it is clear, to the point and inciteful.

Hmm - From where does Interactive broker get his insight into incitement ?
:cheesy:

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#### ZEPPO

##### Well-known member
Robertral said:
Anyone who is interested in reading the basics of option pricing should buy "Futures, Options and other Derivatives" by Hull.....It's a great book....I wouldn't read second hand information from a net article on a Forum like this.
It's certainly a bulky one - I received my copy today, and a cursory look through its pages tells me it is all I need to get a mighty, skull splitting headache!
Seriously, now, John C. Hull text is impressive, and to know about the subject, it is probably one of the best around (Lawrence McMillan is another one, to be read with a rich supply of analgesics at hand).
There is a snag, though: Professor Hull is, er, a professor, ie., a teacher, so I expect a lot of theory (great to pass my ACCA exams - #@!!# Paper 3.7!) but I'm not really sure the content focuses on what traders need, that is, real, down-to-earth stragies which work.
I found much more palatable Guy Cohen's "Options made Easy", where the subject is explained in a simple, easy to read (and absorb) way, and also where the implemetation of a couple of strategies or two are analysed. No fancy maths here.
Still, great text.
Eduardo.

#### grantx

##### Senior member
Eduardo,

Think the underlying is going to rise? Buy a call. Think it’s going to fall? Buy a put.

It isn’t simply a question of what’s right regarding an option strategy. It’s also what’s better, what’s worse, what’s right, what’s wrong, and why? What and where is your risk/exposure, profit potential; what are the greeks telling you?

I would argue the greater the understanding of the theoretical, the greater the chance of better profits (or less loss). Further, you’ll see bullshti a mile off.

Look at the following link. Note: The original question is at the foot of the page, not the top. Then look at the responses, especially from FDAXHunter (he’s the best I’ve come across). This is heavy stuff but it illustrates my point.

http://www.nuclearphynance.com/Show Post.aspx?PostIDKey=3207

Grant.

#### ZEPPO

##### Well-known member
grantx said:
Eduardo,

Think the underlying is going to rise? Buy a call. Think it’s going to fall? Buy a put.

It isn’t simply a question of what’s right regarding an option strategy. It’s also what’s better, what’s worse, what’s right, what’s wrong, and why? What and where is your risk/exposure, profit potential; what are the greeks telling you?

I would argue the greater the understanding of the theoretical, the greater the chance of better profits (or less loss). Further, you’ll see bullshti a mile off.

Look at the following link. Note: The original question is at the foot of the page, not the top. Then look at the responses, especially from FDAXHunter (he’s the best I’ve come across). This is heavy stuff but it illustrates my point.

http://www.nuclearphynance.com/Show Post.aspx?PostIDKey=3207

Grant.
OK, I am not a options trader; but I know enough about options to realise that this is a strategic instrument, quite different to a futures contract or a CFD - after all, I am going to attempt a professional examinayion on the subject!
Grant, I do not know what your point is, but if you "think that the underlying is going to rise? Buy a call. Think it’s going to fall? Buy a put", then I am sorry to say that you haven't the foggiest about options! You are using them as a proxy for the underlying! Wouldn't you be better trading a CFD?
If you think the underlying is going to fall, then you SELL a call, and if you think it is going to rise, then you SELL a put (assuming your broker let you do it)! These are strategic instruments where time is against the buyer and in favour of the seller, not a CFD!
Let me put it in another way: to speculate the way you put it, a buyer has to get right DIRECTION and TIME - if the market moves sideways, the buyer is in trouble!
On the other hand, the seller only needs to get right the DIRECTION as time is in his favour - if the market moves sideways, then "yippee!", where's that Ferrarri brochure? And, Grant, I think everybody knows in this forum how tricky it can be to get direction right, right?
In my humble opinion, options are good for hedging, not for speculating, unless you are a professional, of course; these guys, by virtue of the low commission they pay (something to which neither you nor I have access to) can construct strategies which virtually guarantee them a profit.
Just think about it: why did Myron Scholes get a Nobel Prize? And who benefit the most from his discovery, the buyer or the seller? And who are the biggest seller of options, private traders or institutions?
Elemental, dear Grant , elemental.
Eduardo.

#### grantx

##### Senior member
Eduardo,

My opening remark, “Think the underlying is going to rise? Buy a call. Think it’s going to fall? Buy a put.” was a flippant point. I thought this would have been obvious given my previous, and following remark, and my support for the Hull recommendation.

The point I was trying to make, obliquely, was that options are never as simple as this. Again, this is borne out by the link I provided. Please read the link.

Staying with basic puts and calls, if you think the underlying is going to fall, you would buy a put; if you are correct in your assumption, there will be a corresponding rise in implied volatility. Therefore, you benefit on two fronts – an increase in put premium through falling underlying; plus additional increased premium through higher implied volatility (in simple terms, time value). Rarely (I’ve never seen it) does implied volatility fall (decreasing premiums) when the underlying is falling. So, buy put options when volatility is low and you think volatility will fall further. Don’t sell calls – you’ll be hit by rising implied.

The opposite applies to calls: buy calls when you think the underlying is rising but only where implied volatility is low and you expect it to remain flat. You will benefit through rising premiums, but low implieds have a tendency to rise which while raising the value of the premiums, can also lead to a decreasing underlying price which will reduce the value of the underlying and the option premiums. Don’t sell puts if implied is low and is expected to rise or you’ll be hit on two fronts – increasing premiums through rising underlying, plus additional premium increase through rising implied volatility.

These are less risky compared to selling calls or puts with a low implied – both would be hit by rising implied volatility.

Time is against the buyer of puts and calls (negative theta) when implied is high; it is against the seller (positive theta) when implied is low.

Of course, doing the opposite of what I’ve suggested will not automatically lead to a loss, but you will not be buying at the optimal time.

On these terms – any terms - options are hardly a proxy for the underlying – the underlying does not have the additional characteristics of options - risk premium (implied volatility), theta (time decay), delta, gamma, vega.

“I'm not really sure the content focuses on what traders need …strategies which work.”

You won’t know if, how, or why a strategy works until you know their risk exposures, where the protection and reward lie. Unfortunately, determination of the greeks and implied volatility entail “fancy maths”. Or you could just ignore them. I don’t think they’ll be in your exam.

Obviously, when you steal yourself away from cosy Cohen’s work and read Hull, perhaps some of this may become apparent. Unless you wish to become trader for Mill’s and Boon.

Another link: Theoptionclub.com You’ll have to register (free). Just read these two guys: Michael Catolico and Christopher Smith’s analyses of the various questions re strategies put forward for discussion.

Not so elementary, my dear Eduardo.

Grant.

#### ZEPPO

##### Well-known member
grantx said:
Eduardo,

My opening remark, “Think the underlying is going to rise? Buy a call. Think it’s going to fall? Buy a put.” was a flippant point. I thought this would have been obvious given my previous, and following remark, and my support for the Hull recommendation.

The point I was trying to make, obliquely, was that options are never as simple as this. Again, this is borne out by the link I provided. Please read the link.

Staying with basic puts and calls, if you think the underlying is going to fall, you would buy a put; if you are correct in your assumption, there will be a corresponding rise in implied volatility. Therefore, you benefit on two fronts – an increase in put premium through falling underlying; plus additional increased premium through higher implied volatility (in simple terms, time value). Rarely (I’ve never seen it) does implied volatility fall (decreasing premiums) when the underlying is falling. So, buy put options when volatility is low and you think volatility will fall further. Don’t sell calls – you’ll be hit by rising implied.

The opposite applies to calls: buy calls when you think the underlying is rising but only where implied volatility is low and you expect it to remain flat. You will benefit through rising premiums, but low implieds have a tendency to rise which while raising the value of the premiums, can also lead to a decreasing underlying price which will reduce the value of the underlying and the option premiums. Don’t sell puts if implied is low and is expected to rise or you’ll be hit on two fronts – increasing premiums through rising underlying, plus additional premium increase through rising implied volatility.

These are less risky compared to selling calls or puts with a low implied – both would be hit by rising implied volatility.

Time is against the buyer of puts and calls (negative theta) when implied is high; it is against the seller (positive theta) when implied is low.

Of course, doing the opposite of what I’ve suggested will not automatically lead to a loss, but you will not be buying at the optimal time.

On these terms – any terms - options are hardly a proxy for the underlying – the underlying does not have the additional characteristics of options - risk premium (implied volatility), theta (time decay), delta, gamma, vega.

“I'm not really sure the content focuses on what traders need …strategies which work.”

You won’t know if, how, or why a strategy works until you know their risk exposures, where the protection and reward lie. Unfortunately, determination of the greeks and implied volatility entail “fancy maths”. Or you could just ignore them. I don’t think they’ll be in your exam.

Obviously, when you steal yourself away from cosy Cohen’s work and read Hull, perhaps some of this may become apparent. Unless you wish to become trader for Mill’s and Boon.

Another link: Theoptionclub.com You’ll have to register (free). Just read these two guys: Michael Catolico and Christopher Smith’s analyses of the various questions re strategies put forward for discussion.

Not so elementary, my dear Eduardo.

Grant.
I guess we have a disagreement here, or maybe it is because I simply would not buy puts or calls to speculate (I'd do that with CFD's, or in the case of indices, spreadbetting - it's tax free, for now).
I'm sorry, I couldn't get your point, and I did read the link, that's what confused me, I guess, as I was trying to make that very point: options are not so straightforward to deal with.
I'm afraid that yes, I have got to contend with fancy maths in the exam: Black-Scholes, and we are not talking here about stocks or indices, but Forex and Exchange Rates, collars and others strategies, involving futures contracts, on which, by the way, options can be constructed.
Gary Cohen is probably the most suitable for the private trader; I've got a text by Lawrence McMillan, with is probably on a par with John Hull's, except that McMillan is a trader, so the focus is pretty much on strategy rather than theory- with fancy maths, too.Please note, I do enjoy John Hull's text, at least what I have read so far (I'm on the second chapter).
Personally, I would use options only as a form of hedging, or if you prefer, insurance, on a portfolio of shares; for speculation, I think that there are better instruments, such as CFDs, but then, that is my opinion. If it works for you, then by all means, use them - that is why we are here for, to make money.
Eduardo.

#### Profitaker

##### Established member
Eduardo

Comparing options to CFD’s is like comparing a piece of chalk to a lump of cheese !

A CFD will move % for % with the underlying, in other words they are linear derivatives. An option however, will not. It may move more than % for % with the underlying or less, depending on many factors. Options are non-linear derivatives.

There are so many option strategies that would out perform a CFD for any given market view, it’s worth having a closer look at options IMHO.

Your point about time being in “favour” of the seller is not true, at least not in the sense that you mean it. The premium paid for the time value of any option is a function of the underlying volatility. If the volatility (implied) in the option is correct, then over the long run you will do no better than break-even, regardless of whether you sell or buy the option. If there was any inherent advantage in selling rather than buying options, or vice versa, then everyone would be driving around in Ferraris, don’t you think ?

#### grantx

##### Senior member
Eduardo,

Good luck with the exam.

Grant.

#### ZEPPO

##### Well-known member
Profitaker said:
Eduardo

Comparing options to CFD’s is like comparing a piece of chalk to a lump of cheese !

A CFD will move % for % with the underlying, in other words they are linear derivatives. An option however, will not. It may move more than % for % with the underlying or less, depending on many factors. Options are non-linear derivatives.

There are so many option strategies that would out perform a CFD for any given market view, it’s worth having a closer look at options IMHO.

Your point about time being in “favour” of the seller is not true, at least not in the sense that you mean it. The premium paid for the time value of any option is a function of the underlying volatility. If the volatility (implied) in the option is correct, then over the long run you will do no better than break-even, regardless of whether you sell or buy the option. If there was any inherent advantage in selling rather than buying options, or vice versa, then everyone would be driving around in Ferraris, don’t you think ?
Er... there's that small thing, leverage - you only need a percentage of the capital required to buy shares when trading CFDs, which is the point about trading them; I don't know about Ferraris, but does the words "Where are the customers yatchs?" sound familiar to you?
But of course that you can construct strategies which outperform CFDs, and the lower the commissions, the better, which is why professionals use them!
And you, as a (I suppose) private trader, how many strategies can you construct where commissions do not eat your profits?
I don't know, I'm gonna have to make a drawing here ..."Options are non-linear derivatives" THAT IS MY POINT!! To make profits, you must by when volatility is low, sell when it is high!
If I hold a share and it has just had a good run when the price went up, it is going to consolidate; time to sell a call! Or not? I said before, options are, in MY VIEW, strategic instrument: if the share goes up, fine, I get assigned and goodbye; I'll buy again when the security drops in price; if not, I pocket the premium!
Conversely, if I hear some bad news, then I buy a put - for INSURANCE and not for SPECULATION!
Guys, I hope I got my point across now! If you make money trading all types of fancy options strategies (or some basic ones, for that matter) then fine, go for it; but for speculation (also called "trading") I prefer CFDs or spreadbetting; after all, we are here to make money, aren't we?
Eduardo.

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