The Complete 411 on How Options Pricing Works

Breaking down options pricing

Mar 11, 2021 at 11:31 AM
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    The price one pays to buy options is called options premium, which is fairly straightforward. Contrastingly, the process that determines the value of this option premium is both multifaceted and complex. There are several factors that influence the value that one will pay to buy options contracts. Understanding these factors becomes pivotal in determining the most suitable time to buy or sell options. If, after completing this article, you still find yourself hesitant to trade options on your own, consider checking out one of Schaeffer's beginner's options trading newsletters. Our options trading newsletters rely on Schaeffer's experts' understanding of options and let you sit back and benefit from our 40+ years of experience. 

    Extrinsic and Intrinsic Value

    The ultimate goal of options trading is to make a profit, clearly. The value of this profit revolves around the strike price of the options, the price you pay as premium, and the current underlying stock price. In application, intrinsic value becomes the difference between the stock price and the strike price that helps you make a profit. The options will have the highest intrinsic value when the difference between these two variables is the greatest. If you earn no profit when exercising your options at the expiration date, that means your options had zero intrinsic value. When an option holds significant intrinsic value, it's referred to as an in-the-money option.

    If a put option has high intrinsic value, you would sell the stock at a strike price higher than the current price of that stock in the market. Alternatively, for a call option, the strike price has to be lesser than the current price of the stock in order for you to gain a profit. Subscribe to the best options newsletter to understand how you can maximize your profits while keeping in mind the intrinsic value of options.

    The easiest way to understand what the extrinsic value of options is to subtract the options' intrinsic value from its total value (the value you paid for its premium). An out-of-the-money option is one that possesses a high extrinsic value. If it's an out-of-the-money call option, its strike price will be greater than the underlying asset's market price. Whereas, if it's an out-of-the-money put option, its strike price will be lower than the underlying asset's market price. All of this may seem like a lot of complex information to take in, but the more you commit to understanding options, the easier all of this will come for you.

    Options Volatility: Historical Volatility and Implied Volatility

    The volatility of an option is the fluctuations that the market price of the stock is susceptible to. Thus, volatility becomes a very crucial factor in deciding the premium that you are going to pay for options. In a nutshell, highly volatile options have higher premiums. This is because they accentuate the probability of profits through the upward and downward potential of the options. If you own a call option, the upward volatility will increase the chances of earning a higher profit. But if you own a put option, the downward volatility will help you sell the underlying asset at a higher price.

    There are two kinds of options volatility that you should know about before trading options. The first of these is historical volatility. This kind helps you understand the magnitude of the fluctuations in the value of the underlying stock statistically. The most common method employed to do this is through using standard deviations, however, there are several others too. If the stock has undergone severe fluctuations in its value in the past, it is classified as highly risky. Along with this high risk, comes the probability of earning a significant profit, and thus, valuable options.

    Implied volatility is the second common type of volatility. As the name already suggests, implied volatility revolves around the predicted changes in the stock price. This type of volatility becomes extremely important because it helps you understand the market expectations through the eyes of market experts. You can then use this information to estimate the probability of the stock prices fluctuating in the future. Remember, the greater the fluctuation, the more room for you to exercise your profitable options.

    Options trading may not be everyone's cup of tea. However, if you are eager to step into options trading, Schaeffer's publishes the best options newsletters that will provide the guidance required to get started.

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