What we'll cover
What factors determine option pricing
How option contract pricing works
Important option pricing models
Fortunately, if you understand how car insurance pricing works, then you’re well on your way to understanding option pricing.
What are the factors that determine an option price?
The five factors that determine car insurance prices are basically the same factors that drive options prices. Our car insurance comparison offers a great way to keep them straight.
1. Stock price
Using our car insurance example, stock price is the price of the asset. It’s similar to a premium in car insurance. Imagine you’re insuring a Volvo and a Yugo: Which car will cost you more? It’s a no-brainer that the higher-priced asset (the Volvo) will cost more to insure. Similarly, options on a $100 stock will typically cost more than those on a $10 stock.
2. Strike price (a.k.a. exercise price)
Strike price is the price at which you can exercise the option – akin to an insurance deductible. The larger the deductible, the lower the cost of the policy. If you’re willing to take a larger deductible on your car insurance, your insurance costs drop. The deductible-equivalent in the options world is your strike price. If you buy a put option to protect a stock position you own, and you choose to buy a really out-of-the-money strike price, you’re accepting more risk, so the cost of the option drops to reflect this higher “deductible,” or risk, that you’re willing to accept.
3. Expiration date
Expiration date is the date an options contract expires — that is, it no longer exists. It’s like time remaining on your insurance policy. The more time you have, the higher the cost. Remember: Time is money, both in car insurance and in the options market. A six-month car insurance policy will cost less than insurance for a full year. Same thing for options: A contract with six months to expiration will cost less than a one-year option contract.
4. Interest rate and dividends
There’s one twist in that metaphor: Dividends. Whereas car insurers don’t pay anything like dividends to car owners, stocks will sometimes pay a dividend to shareholders. Option pricing model calculations take potential dividends into account.
5. Volatility (a.k.a. risk)
Even if a $100 stock winds up at exactly $100 one year from now, it still could have a great deal of historical volatility. After all, it’s possible that the stock could have traded as high as $175 or as low as $25 at some point. And, if there were wide daily price ranges throughout the year, it would indeed be considered a historically volatile stock. The more volatile a stock, the riskier, which means “insuring” it with options will be more costly.
How does option contract pricing work?
Let’s start with two key variables: Intrinsic value and time value.
Intrinsic value
Intrinsic value is the in-the-money portion (if any) of a call or put option contract’s current market price. Obviously, only in-the-money options have intrinsic value.
Time value
Want to dig deeper? Here are some ways.
What are some option pricing models and calculations?
If stats are your thing, read on for an overview of two prominent models and where you can learn more.
Black-Scholes and binomial models
One more thing to note: Option pricing models typically generate something called the option Greeks: Delta, gamma, theta, vega and rho. So, it’s a good idea to take time to meet the option Greeks.
Why does option pricing theory matter?
In essence, understanding option pricing theory moves you beyond the world of an option trading novice and positions you to make more informed investment decisions.
