Last week we gave an introduction to options. The risks in trading options were also outlined. To better understand this, we will now discuss the factors involved in option pricing. Option pricing can be done using mathematical models such as Black-Scholes or Binomial pricing models.
Options can provide leverage. This means an option buyer just by paying a small premium for market exposure in relation to the contract value can see large percentage gains from comparatively small, favorable percentage moves in the underlying index. Leverage also has its implications. If the underlying stock price does not rise or fall as expected during the lifetime of the option, leverage can magnify the investment’s percentage loss. Options offer their owners a predetermined, set risk.
However, if the options expire with no value, this loss can be the entire amount of the premium paid for the option. An uncovered option writer, on the other hand, may face unlimited risk
The actual price of an option can be determined when you consider all factors that are responsible for its actual price. There are several factors involved in the valuation of options. These include the current stock price, the intrinsic value, time to expiration or the time value, volatility, interest rates, and cash dividends paid.
While all other factors could be easy to understand, the time decay and volatility need certain elaboration.
Generally, the longer the time remaining until an option’s expiration, the higher its premium will be. This is because then there is a greater possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an option’s price remaining the same, the time value portion of an option’s premium will decrease (or decay) with the passage of time.
Volatility is the tendency of the underlying security’s market price to fluctuate either up or down. It reflects a price change’s magnitude. Thus, it is a major factor in determining an option’s premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. As the volatility of an underlying stock increases, the premiums of both calls and puts of that stock increase, and vice versa.
Next week we will bring the strategies commonly used in the market and how to benefit from these.
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