How Are Stock Options Priced - Understanding the Price Behavior of Options

Nov. 3, 2010 - PRLog -- How Are Stock Options Priced

A stock options premium is simply the current market value of the option. In other words, it's how much it costs to buy the stock option. In trading it's also referred to as the "ask price."

Understanding options pricing is a complex topic and probably one of the toughest concepts you'll encounter as you learn about options trading. However, I'll present you with the basics and a few rules of thumb to keep in mind.

If you just blindly start trading stock options without having at least a basic understanding of why options behave the way they do, then you're going to be in trouble and possibly lose a great deal of money. It's like being a person who doesn't understand that it's a bad idea to go swimming in shark infested waters when you have a bleeding leg.

Stock options are very different from shares of stock. They have very specific and unique characteristics. It is these characteristics that are going to determine if you are able to make a profit from the purchase of the option.

Stock Price Effect

   * With a stock price "increase", a call options premium will increase (you'll make money), and the put options premium will decrease (you'll lose money).
   * With a stock price "decrease", a Put options premium will increase (you'll make money), and the Call options premium will decrease (you'll lose money).


Strike Price Effect

The strike/exercise price of an option is the "price" at which the stock will be bought or sold when the option is exercised. There are three different terms for describing the stock price to strike price relationship Get your How Are Stock Options Priced @ http://slackers-trading3.blogspot.com/?tid=prlog021110 and be Successful forever!

   * Out of the Money: Calls (stock price lower than strike price), Puts (stock price higher than strike price)
   * At the Money: stock price and strike price are the same or close to being the same
   * In the Money: Calls (stock price higher than strike price), Puts (stock price lower than strike price

The more an option is in-the-money (ITM) the more expensive it will be, because it has more value to the holder. This value is called intrinsic value.

The farther an option is out-of-the-Money (OTM), the cheaper it will be.

An at-the-Money (ATM) option, price wise, is in the middle and is slightly cheaper than an "ITM" option.

Options Premium and Extrinsic Value

The extrinsic value (time value) of an option is the dollar value that is placed on the remaining life of the option.

   * The farther out you go with the options expiration month the higher the cost will be.
   * The extrinsic value portion of the options price dwindles down on a daily basis, this is called time decay.
   * Once an option moves to ITM then it will start gaining value rapidly and the effect of time decay will be negligible because intrinsic value will take over.


The Effect of Volatility

Option Volatility is a measure of risk / uncertainty.

   * High volatility: higher option premium
   * Low volatility: lower option premium


Options Premium Illustration

Here is an over simplified illustration so you can visually see how all the components come together to make up the options price:

ITM($3) + Time Value ($1) + Volatility ($1) + Interest rate ($.60) + Dividend ($.10) = $5.70 Option cost/premium. Get your How Are Stock Options Priced @ http://slackers-trading3.blogspot.com/?tid=prlog021110 and be Successful forever!

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