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Pricing Options

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Before venturing into the world of trading options, investors should have a good

understanding of the factors that determine the value of an option. These include the

current stock price, the intrinsic value, time to expiration or the time value, volatility,

interest rates and cash dividends paid.

There are several options pricing models that use these parameters to determine the

fair market value of the option. Of these, the Black-Scholes model is the most widely

used. In many ways, options are just like any other investment in that you need to

understand what determines their price in order to use them to take advantage of

moves the market.

Let's start with the primary drivers of the price of an option: current stock price, intrinsic

value, time to expiration or time value, and volatility. The current stock price is fairly

obvious. The movement of the price of the stock up or down has a direct - although not

equal - effect on the price of the option. As the price of a stock rises, the more likely the

price of a call option will rise and the price of a put option will fall. If the stock price goes

down, then the reverse will most likely happen to the price of the calls and puts.

Intrinsic Value

Intrinsic value is the value that any given option would have if it were exercised today.

Basically, the intrinsic value is the amount by which the strike price of an option is in the

money. It is the portion of an option's price that is not lost due to the passage of time.

The following equations can be used to calculate the intrinsic value of a call or put

option :

Current Price – Call Strike Price

Underlying Stock's Current Price

The intrinsic value of an option reflects the effective financial advantage that would

result from the immediate exercise of that option. Basically, it is an option's minimum

value. Options trading at the money or out of the money have no intrinsic value.

Time Value

The time value of options is the amount by which the price of any option exceeds the

intrinsic value. It is directly related to how much time an option has until it expires as

well as the volatility of the stock. The formula for calculating the time value of an option

is:

The more time an option has until it expires, the greater the chance it will end up in the

money. The time component of an option decays exponentially. The actual derivation of

the time value of an option is a fairly complex equation. As a general rule, an option will

lose one-third of its value during the first half of its life and two-thirds during the second

half of its life. This is an important concept for securities investors because the closer

you get to expiration, the more of a move in the underlying security is needed to impact

the price of the option. Time value is often referred to as extrinsic value.

Time value is basically the risk premium that the option seller requires to provide the

option buyer the right to buy/sell the stock up to the date the option expires. It is like an

insurance premium of the option; the higher the risk, the higher the cost to buy the

option.

An option's time value is also highly dependent on the volatility in that the market

expects the stock will display up to expiration. For stocks where the market does not

expect the stock to move much, the option's time value will be relatively low. The

opposite is true for more volatile stocks or those with a high beta, due primarily to the

uncertainty of the price of the stock before the option expires. In the table below, you

can see the GE example . It shows the trading price of GE, several strike prices and the

intrinsic and time values for the call and put options.

General Electric is considered a stock with low volatility with a beta of 0.49 for this

example.

Amazon.com Inc. (AMZN) is a much more volatile stock with a beta of 3.47 (see Figure

2). Compare the GE 35 call option with nine months to expiration with the AMZN 40 call

option with nine months to expiration. GE has only $0.20 to move up before it is at the

money, while AMZN has $1.30 to move up before it is at the money. The time value of

these options is $3.70 for GE and $7.50 for AMZN, indicating a significant premium on

the AMZN option due to the volatile nature of the AMZN stock.

This makes - an option seller of GE will not expect to get a substantial premium

because the buyers do not expect the price of the stock to move significantly. On the

other hand, the seller of an AMZN option can expect to receive a higher premium due to

the volatile nature of the AMZN stock. Basically, when the market believes a stock will

be very volatile, the time value of the option rises. On the other hand, when the market

believes a stock will be less volatile, the time value of the option falls. It is this

expectation by the market of a stock's future volatility that is key to the price of options.

The effect of volatility is mostly subjective and it is difficult to quantify. Fortunately, there

are several calculators that can be used to help estimate volatility. To make this even

more interesting, there are also several types of volatility - with implied and historical

being the most noted. When investors look at the volatility in the past, it is called either

historical volatility or statistical volatility. Historical Volatility helps you determine the

possible magnitude of future moves of the underlying stock. Statistically, two-thirds of all

occurrences of a stock price will happen within plus or minus one standard deviation of

the stocks' move over a set time period. Historical volatility looks back in time to show

how volatile the market has been. This helps options investors to determine which

exercise price is most appropriate to choose for the particular strategy they have in

mind.

Implied volatility is what is implied by the current market prices and is used with the

theoretical models. It helps to set the current price of an existing option and assists

option players to assess the potential of an option trade. Implied volatility measures

what option traders expect future volatility will be. As such, implied volatility is an

indicator of the current sentiment of the market. This sentiment will be reflected in the

price of the options helping options traders to assess the future volatility of the option

and the stock based on current option prices.

A stock investor who is interested in using options to capture a potential move in a stock

must understand how options are priced. Besides the underlying price of the stock, the

key determinates of the price of an option are its intrinsic value - the amount by which

the strike price of an option is in-the-money - and its time value. Time value is related to

how much time an option has until it expires and the option's volatility. Volatility is of

particular interest to a stock trader wishing to use options to gain an added advantage.

Historical volatility provides the investor a relative perspective of how volatility impacts

options prices, while current option pricing provides the implied volatility that the market

currently expects in the future. Knowing the current and expected volatility that is in the

price of an option is essential for any investor that wants to take advantage of the

movement of a stock's price.

investment instruments. The model develops partial differential equations whose solution, the

Black–Scholes formula, is widely used in the pricing of European-style options.

The model was first articulated by Fischer Black and Myron Scholes in their 1973 paper, "The

Pricing of Options and Corporate Liabilities." The foundation for their research relied on work

developed by scholars such as Jack L. Treynor, Paul Samuelson, A. James Boness, Sheen T.

Kassouf, and Edward O. Thorp. The fundamental insight of Black–Scholes is that the option is

implicitly priced if the stock is traded. Robert C. Merton was the first to publish a paper

expanding the mathematical understanding of the options pricing model and coined the term

Black–Scholes options pricing model.

Model assumptions

The Black–Scholes model of the market for a particular equity makes the following explicit

assumptions:

rate. This restriction has been removed in later extensions of the model.

• The price follows a Geometric Brownian motion with constant drift and

volatility. This often implies the validity of the efficient-market hypothesis.

• There are no transaction costs or taxes.

• Returns from the security follow a Log-normal distribution.

• The stock does not pay a dividend (see below for extensions to handle

dividend payments).

• All securities are perfectly divisible (i.e. it is possible to buy any fraction of a

share).

• There are no restrictions on short selling.

• There is no arbitrage opportunity

• Options use the European exercise terms, which dictate that options may

only be exercised on the day of expiration.

From these conditions in the market for an equity (and for an option on the equity), the authors

show that "it is possible to create a hedged position, consisting of a long position in the stock and

a short position in [calls on the same stock], whose value will not depend on the price of the

stock." Several of these assumptions of the original model have been removed in subsequent

extensions of the model. Modern versions account for changing interest rates (Merton, 1976),

transaction costs and taxes (Ingerson, 1976), and dividend payout (Merton, 1973).

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