Any trader will admit that understanding and, more importantly,
mastering the concept of option pricing and its correct value
determination is mandatory for successful trading.
The actual price of an option is determinable when you consider all
factors that are responsible for its actual price. Let’s take petroleum
for instance. Final prices of petroleum are dependent on consumer
demand, crude oil price, seasonal changes, local and state taxes and
refinery productivity etc. When you buy or sell options and wish to know
or calculate its price beforehand, you may resort to a mathematical
formula such as the Black Scholes model. You just need to consider the
variables the model comprises and you will arrive at the appropriate
price.
There are several factors involved in the valuation of options. These are:
1. The Current Price of the Stock: This depends on
logical thinking. If a call option interests you and gives you the
opportunity to pick up stocks of X company, say, at Rs 390 a share, then
most naturally you would be willing to pay in excess for the aforesaid
call when the particular stock trades at Rs 390 as against its trading
at Rs 400. This is solely because the call option gets much closer to
being at an ITM of Rs 49 than it would have been if it traded at Rs 40.
Put options, however, work oppositely.
2. The Strike Price : This may be defined as the price payable
by the call owner to purchase stock, while a put owner decides to sell
his stock. This is similar to the example cited above. One tends to pay
more for the right to purchase stock at Rs 380 than Rs 400. The average
investor would of course, prefer such rights that enable him to
purchase stocks at lower prices at any moment of the day. This makes
calls more expensive with the strike price moving downwards. Similarly,
puts are more expensive value wise when the strike price spirals.
3. Option Type: The option value depends on its type. There
are basically two types: Put or Call. The difference clearly hinges on
which side you exactly stand of the market or trade. This is probably
the simplest variable comprehensible to the average trader.
4. Period Before Expiry: It needs to be borne in mind that all
options come with a definite lifespan and tend to expire on or after a
certain date. Therefore, the value of an option increases with
additional time. The more time available until expiry, the greater are
the chances of making profitable moves.
5. Interest Rates: This is an insignificant factor while
ascertaining the option’s price. As interest rates rise, call option
values rise too. When the trader opts for the call option as against the
stock, then any extra cash in his kitty should earn interest for him,
theoretically at least. Of course, this doesn’t happen in real world
situations but the basic theory makes sense.
6. Dividends : When the stock trades and yet, its holder gets
no dividends, the situation is termed ex-dividend and the price of the
stock gets diminished by the amount of dividend payable. With rising
dividends, put values increase while call values decrease.
7. Volatility : This is considered to be the big variable. In
simpler terms, volatility is the difference recorded in day-to-day stock
prices. It is also referred to as swings that affect a stock’s prices.
The more volatile stocks are more frequently subject to a varying
strike price level as compared to their non-volatile counterparts. With
big moves, the chances are higher to make money and the investor shifts
out of the Blue sphere. Thus options on volatile stocks are definitely
more expensive than the less or non-volatile ones. It is always prudent
to remember, therefore, that even the minutest of changes in volatility
estimates impact options prices substantially. Volatility is more often
viewed as an estimate and using just an estimate and future volatility
particularly, makes it virtually impossible to correctly calculate the
right option value.
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