Knowing Your Option's Value

In order to understand the value of your option, you should become familiar with the concept of stock option valuation. Valuing options can involve fairly advanced mathematics. You do not need to know the exact details of the Black Scholes formula, or the other formulas used, but you should understand the underlying concepts.

Components

Options prices are also called premiums. They have two components and are determined by six factors. The price changes are indicated by six factors, which are called Greeks. Note that interest rates and stock dividends  are not generally important to options traders. The two basic components of an option are:

  • Intrinsic Value: Intrinsic value is the amount by which an option is in the money. “In the money” is a popular term used in options trading , and  is abbreviated by the term ITM.
  • Time Value: Time Value is measured by the length of time until expiration. The closer to the expiration date an option is, the less time value it has. This concept is especially important to know if you are selling options.

Factors That Influence The Price Of Options

  • The Price of the Underlying Stock: As the price of the underlying stock goes up, the price of the option changes. If the option is a call option, the price increases. If it is a put, it decreases. The converse if true if the price goes down. The rate of this change is indicated by delta, the Greek symbol.
  • The Strike Price: The strike price of the option, relative to the option price influences the price of the option. It determines the intrinsic value of the option. In a call option, if the strike price is higher than the stock price, the option is out of the money and is therefore worthless. If this is true for a put, it is in the money.
  • The Time Value of the Option: The life of the option is worth money. The rate by which the time value of the option changes is called theta.        
  • Volatility: A volatile stock is a risky stock. Therefore the option price for this stock will be higher. If the underlying stock is relatively stable, the price will be relatively low.  A highly volatile stock will generally yield better premiums, so is advantageous to the seller in this way.
  • Historical Volatility: Historical volatility is the how the underlying stock has changed value in the past.        
  • Implied Volatility: Implied volatility uses a special mathematical formula to calculate how volatile the market thinks that the stock will be in the future.

A Note About Greeks

Options prices and price changed are measured by indicators called Greeks. Some Greeks were mentioned in this article. Options traders use 6 Greeks to measure prices: delta, gamma, theta, vega, rho, and zeta. Most of these concepts are not necessarily relevant to the average trader. It is more important to learn the basic concepts, and how to recognize patterns in the stock price.

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