Options Education Series: Options Pricing

There are six factors that together dictate the price at which all options trade at, these include:

1. Strike Price: aka the “Strike,” is the price at which the owner of an option is allowed exercise their right. In the case of a call option, they are allowed to purchase the security at the strike price. In the case of a put, the purchaser is allowed to sell the security at the strike price.

This affects the price of an option insomuch as it determines if the option has any intrinsic value. If the underlying trading in-the-money, intrinsic value, and thus an options price, increased.

2. Time Until Expiration: the further away from expiration an options is, the more time premium an option carries. Options are decaying assets, meaning over time they loose a predetermined amount (known as time premium) up until expiration.

3. The Underlying's Movement: a change in the underlying security will result in a respective increase or decrease in the value of the option. Options are derivatives, meaning that their value is derived from another security.

4. Dividends: an options value may have a small effect due to the underlying's dividend payout and will move higher or lower if the underlying dividend is increased or decreased.

5. Interest Rates: Risk-free interest rates (Treasuries) also effect options due to effect of cost-of-carry; this means the interest rate options holders could take down instead of holding decaying options.

6. Volatility: this is the single largest aspect that effects the movement and pricing of an option. It is also the hardest to quantify. Simply, volatility is a measure of risk, therefore if the underlying's price is thought the have increased risk, this will be reflected in options prices. Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying price levels and vice versa for lower volatility expectations.

*Portions of this series have been adapted from free educational materials distributed by The Options Industry Council and The Chicago Board Options Exchange.