Article Options Pricing: The Basic Factors You Should Know

T2W Bot

Staff member
1,465 62
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...
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TWI

Senior member
2,527 252
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
446 3
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.
 

Rhody Trader

Senior member
2,620 264
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.
 

Rhody Trader

Senior member
2,620 264
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.
 

blackcab

Established member
523 51
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
2,331 223
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
5,167 746
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 ?
:eek: :cheesy:
 
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ZEPPO

Well-known member
335 11
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
2,331 223
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
335 11
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.
 
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