OPTION PRICING: How Is Option Priced? (Part 2)

In Part 1, we know that there are 6 factors that affect option's price: option’s strike price, stock price, time to expiration, implied volatility, interest rate, and dividend.

Nevertheless, the impact of interest rate and dividend are often considered negligible as compared to the other factors. Most of the time, for each level of strike price, an option’s price will move due to the movement of underlying stock price, volatility and time.

The Black-Scholes formula can be used to calculate the theoretical value of an option based on the above factors.

What is the use of knowing an option’s theoretical value? By knowing the option’s theoretical value, option traders can compare the prevailing option price in the exchange against this theoretical value to determine if a particular option contract is over or under valued, hence helping them in their option trading decision.

Options Calculator / Pricer is normally used to help compute the theoretical value of option price.

THE IMPACTS ON OPTION’S POSITION

Since option’s buyers (long position) will profit when the option price rises after they buy (Buy Low, Sell High), whereas the seller (short position) will profit when the option price falls after they sell (Sell High, Buy Low), the impact of the above factors will also be different.

The following table shows how the major factors (stock price, time to expiration, implied volatility) affect an option’s position.

Example:

Increase in Implied Volatility (IV) would increase option’s price (both calls & puts), assuming other factors unchanged. Hence, this will be favorable for option buyers who will gain if the option price increases (buy low, sell high), but unfavorable for option sellers that will profit if the option price drops (sell high, buy low).

Related Topics:
* Options Trading Basic – Part 1
* Options Trading Basic – Part 2
* Understanding Implied Volatility (IV)
* Option Greeks
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