Options: How Pricing and Value Are Determined
In theory, the value of an option is determined by the value of the underlying stock (or whatever investment vehicle from which the option derives its value). However, this is only part of the story as there are other variables to consider when determining the value of any option. As with any investment, time is a critical factor and always has a role in determining price and overall value.
Options are contracts that grant owners the right to buy or sell 100 shares of an underlying stock for a set price (strike amount) by the expiration date - for a fee, known as a premium. In other words, investors are trying to guess which way the current price of stock will trend in the near future (most options are for 1-year or less while LEAP options may have an expiration date three years into the future). Investors will buy call options when they think stock prices will increase. However, investors will buy put options when they believe that the price of the underlying stock will decrease by the time of expiration.
Generally, the value of an option will not vary as greatly as the underlying stock. However, increased volatility in option value occurs when the expiration date draws close or when it is already "in-the-money." A call option is "in-the-money" when the present price of the underlying stock is higher than the strike price. A put option is considered to be "in-the-money" when the market price is lower than the strike price. When options are "in-the-money" or close to their expiration date, their value will change at a different rate than the underlying stock. However, the Black Scholes formula is a mathematical equation that can be used to approximate the value of an option relative to its market price.
Delta (Δ) in the Black Scholes formula is equal to the amount that the value of the option is expected to move for every 1 point of movement in the price of the underlying stock. Thus, if delta were said to be 0.5 for stock A, then the value of the option for that stock would increase or decrease by 0.5 for every 1 point of fluctuation in the stock price. In addition to being affected by proximity to expiration date and being "in" or "out" of the money, the value of delta may change due to the overall volatility of the underlying stock itself. There are times, however, when the Black Scholes formula fails to predict value of the option.
The overall value of an option is actually determined by six factors: strike price, current market price of underlying stock, dividend yield, prime interest rate, proximity to expiration date, and the volatility of the stock prices over the course of the option. Because these six variables combine in different ways to affect the value of an option, it is possible for the price of the underlying stock to increase while the value of the option falls. The Black Scholes formula may fail when other factors are affecting the value of the option more than current stock price.
The longer the time between when an option is purchased and its expiration date, the more time there is for the current market price to reach the strike price - and hence, the greater the value of the option. An investor may see the value of an option decrease even as the price of the underlying stock increases because the expiration date is nearing. In such cases, the price increases may be too little and too late for the stock to reach the strike price - therefore, the overall value of the option will continue to decrease as the expiration date approaches as it becomes less likely that the strike price will be attained.
As strike price plays such a crucial role in both the value of the option and the potential for profit, it is important for an investor to choose the strike price carefully. The strike price is the anticipated value of the underlying stock at the time of expiration and the farther this amount is from the stock price at the time the option was written, the lower the premium. Larger gaps between strike price and market price are harder to bridge by the expiration date and thus mean increased risk. Lower premiums are charged because it is less likely that the gap can be bridged before the expiration date. However, these options with the higher strike prices also have the biggest potential for profit. Many investors choose to buy and/or sell options with different strike prices to help limit losses while maximizing profits. Such strategies include the "buy/sell condor", "buy/sell butterfly", and "buy straddle" - just to name a few.