Tuesday, April 11, 2006

Option Basics --- Option Price

What determine the price of an option?

Like buy anything else, you need to know whether the current price of an option is fair or not. The factors to determine a stock option’s price are:

1. The price of the underlying stock and the strike price
It is the most important factor. 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.

The price of an option is determined by the difference between the option strike price and the current stock price. The bigger the difference is, the cheaper the option is (at the same expiration date).

For example, if the current price of stock ABC is $10 and you want to buy a call expire in 3 month, the price of the option at strike price $15 would be less expensive than the one at $12.5. If you want to buy a put, the price of $5 would be cheaper then the one at $7.5.

2 .Time and the expiration date
The option's future expiry, at which time it may become worthless, is key factor of every option strategy. Ultimately, time can determine whether your option trading decisions are profitable. To make money in options over the long term, you need to understand the impact of time on stock and option positions.

With stocks, time is a trader's ally as the stocks of quality companies tend to rise over long periods of time. But time is the enemy of the options buyer. If days pass without any significant change in the stock price, there is a decline in the value of the option. Also, the value of an option declines more rapidly as the option approaches the expiration day.

An important concept in option trading is the time value. The option buyer is actually buying time. A longer expiration date is always means higher option price.

3. Volatility
Volatility is considered into the option price. If a stock is volatile, its option price will be higher.

There are some option pricing models available. They require you to put in what the future volatility of the stock will be during the life of the option. Naturally, option buyers don't know what that will be, so they have to try to guess. A common way to make the guess is to check the stock’s history.

4. Supply and demand
The market controls the price. If there are more buyers than the sellers, then the price will go up; otherwise the price will go down.

The option market is very small market. For some unpopular stock, the number of available open contract is very limited. The demand or the supply will drive the market dynamically.

An option trader has to consider this factor. Sometimes, the option trading is not a choice simply because its market size is too small. A big buy or sell might heavily impact the price and reduce the trader’s profit.

5. Interest rate and dividend of the underlying stock
The two impact the option price also. If you use an option price formula, you have to provide such information. For regular people, we might not care them much.

Option is different from stocks. Learning how to use options properly requires a little effort; however, once you knew it, you'll quickly find that options give you more flexibility to tailor the risk and provide you bigger potential of reward.


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