Factors That Determine Option Pricing

Options can be used in a wide variety of strategies, from conservative to high risk. They can also be tailored to meet expectations that go beyond simple directional strategies. So, once you learn basic options terminology, it makes sense to investigate factors that affect an option's price in various scenarios.

When stock traders first begin using options, it is usually to purchase a call or a put for directional trading, in which they expect a stock will move in a particular direction. These traders may choose an option rather than the underlying stock due to limited risk, high reward potential and less capital required to control the same number of shares.

If the outlook is positive (bullish), buying a call option creates the opportunity to share in the upside potential without having to risk more than a fraction of the market value. If bearish, buying a put lets the trader take advantage of a fall without the margin required to sell short.

Many kinds of option strategies can be constructed but the position's success or failure depends on a thorough understanding of the two types of options: the put and the call. Furthermore, taking full advantage of options requires a new way of thinking because traders who think solely in terms of market direction miss all sorts of opportunities.

In addition to moving up or down, stocks can move sideways or trend modestly higher or lower for long periods of time. They can also make substantial moves up or down in price, then reverse direction and wind up back where they started. These kinds of price movements cause headaches for stock traders but give option traders the exclusive opportunity to make money even if the stock goes nowhere. Calendar spreads, straddles, strangles and butterflies highlight a few option strategies designed to profit in those types of situations.

Option traders need to understand additional variables that affect an option's price and the complexity of choosing the right strategy. Once a stock trader becomes good at predicting the future price movement. he or she may believe it is an easy transition from to options but this isn't true. Options traders must deal with three shifting parameters that affect price: price of the underlying security, time and volatility. Changes in any or all of these variables affects the option's value.

There are mathematical formulas designed to compute the fair value of an option. The trader simply inputs known variables and gets an answer that describes what the option should be worth.

Here are the general effects that variables have on an option's price:

1. Underlying Price 

The value of calls and puts are affected by changes in the underlying stock price in a relatively straightforward manner. When the stock price goes up, calls should gain in value and puts should decrease. Put options should increase in value and calls should drop as the stock price falls.

2. Time

The effect of time is easy to conceptualize but takes experience before understanding its impact due to the expiration date. Time works in the stock trader's favor because good companies tend to rise over long periods of time. But time is the enemy of the options buyer because, if days pass without a significant change in the price of the underlying, the value of the option will decline. In addition, the value of an option will decline more rapidly as it approaches the expiration date. Conversely, that is good news for the option seller, who tries to benefit from time decay, especially during the final month when it occurs most rapidly.

3. Volatility

The effect of volatility on an option's price is the hardest concept for beginners to understand. It relies on a measure called statistical (sometimes called historical) volatility, or SV for short, looking at past price movements of the stock over a given period of time.

Option pricing models require the trader to enter future volatility during the life of the option. Naturally, option traders don't really know what it will be and have to guess by working the pricing model "backwards". After all, the trader already knows the price at which the option is trading and can examine other variables including interest rates, dividends, and time left with a bit of research. As a result, the only missing number will be future volatility, which can be  estimated from other inputs

These inputs form the core of implied volatility, a key measure used by option traders. It is called implied volatility (IV) because it allows traders to determine what they think future volatility is likely to be. (For more insight, see The ABCs Of Option Volatility.)

Traders use IV to gauge if options are cheap or expensive. You may hear option traders say that premium levels are high or that premium levels are low. What they really mean is that current IV is high or low. Once understood, the trader can determine when it is a good time to buy options - because premiums are cheap - and when it is a good time to sell options - because they are expensive.

Once you have a firm grasp of the essentials, you'll find that options provide flexibility to tailor the risk and reward of every trade to your individual strategies..