Option Pricing

Pricing options is more difficult than pricing futures because it involves a transaction that may not happen. In theory, the odds of profitability are built into the premium paid, but with variable rewards there is no easy method like the cash and carry to find a fair price.

You can consider the extremes. A call option lets you buy the shares at the option price, regardless of where they are trading on the expiration date. So the option cannot be more expensive than the current price of the shares, otherwise you could buy them right now and have them at the expiration. In practice, depending how far in or out of the money the options are, they would cost much less than this. And with a put option, similarly it cannot cost more than taking a short position in the stock.

The premium you pay for an option can be broken down into two parts. One part is called the intrinsic value, which ranges from zero upwards. This is how much the option is in the money right now. It can’t be negative or below zero, because you do not have to exercise the option. The second part is called the time value, and that represents a chance that the price will change to make the option in the money, or increase the amount by which is in the money. The longer the option has to run, the greater the time value, other things being equal. But the time value shrinks up to expiration, when it equals zero, and you’re left with just the intrinsic value.

Here are some basic pointers to understanding option pricing —

  • The lower strike call is more expensive
  • The higher strike put is more expensive
  • More time to expiration is more expensive
  • At expiration, options are worth their intrinsic value — which could be zero if it is not in the money
  • For any two options on the same stock with the same expiration, the difference in the call prices cannot be more than the difference in the strike prices

If you’re interested in going into greater depth on pricing, the most well-known method is called the Black-Scholes model. It’s quite complex but you’ll usually find that your brokerage firm will give you online access to ratings based on the Black-Scholes model, or you can subscribe to Black-Scholes ratings at the Chicago Board of Options Exchange.

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