Option Pricing

Option Pricing

Options pricing is made up of a real value and a time value. The real value is known as intrinsic value and it is the difference between the strike price and the current stock price.

Consider this example for intrinsic value:
2017-05-05
XYZ’s current stock price: $32.60

June 16, 2017 call options (42 Days)
$32.00 strike with Bid: 1.16 Ask: 1.26

If you were to buy this, you’d pay the asking price at 1.26 per contract. You would now have the right to buy the stock at 32, but the stock is at 32.60. So, this is currently In The Money by .60 The current stock price is 32.60 – 32.00 = .60 and the remaining .66 is the time value

Now look at an Out of The Money example:

$33.00 Strike Bid: 0.61 Ask: 0.70

If the stock would close at this current price at expiration this would expire worthless. You would buy this at the asking price of .70 and this is all time or extrinsic value.

The extrinsic value has a theoretical value and actual value. The extrinsic value is commonly calculated using the Black Scholes option pricing. The actual value is different, because of events that are currently impacting the market. An example of this can be earnings announcements. The Implied Volatility is a reflection of this.

There is the theoretical value of an option is based on the Black Scholes Model and a good explanation can be found by Investopedia: Black Scholes Model. This takes into account 5 variables: option strike price, current stock price, time to expiration, risk-free rate, and volatility.

The volatility is the true unknown in the equation. You can often get an idea of volatility by looking at the chart. A stock that goes from 20 – 40 in a year will have higher option prices than a stock that has a range of 30 – 40.

The difference between the theoretical value and the actual price is implied volatility. Implied volatility takes into account special events or overall market conditions. If a stock is reporting earnings within the expiration will be priced higher. If the overall market is volatile then the option pricing will be higher.