Options can be a very daunting thing to try to understand. Understanding how Options are priced can help alleviate some confusion and give you better clarity on what they are and how they trade. Hopefully, by the end of this, you will have a decent grasp on how Options are priced and why they trade the way they do.

There’s a multitude of ways to calculate the price of an Option. We are going to cover some of the inputs that go into how Options are priced. There are a few other factors that bigger institutions look at. For the purposes of this article, and so that you’re not bored to tears, we’ll keep it straightforward and concise.

Underlying Stock’s/Future’s Price

This is somewhat self-explanatory. Options are derivatives that derive their value from an underlying Stock or Futures Contract. An Option’s value is directly correlated to the underlying asset that it’s connected to.

This makes sense because, ultimately, Options are contracts. They are contracts between the Option’s Buyer, and the Option’s Seller. The Buyer receives “the right but not the obligation to purchase or sell Stock/Futures Contract at a predefined price (Strike Price)”. In exchange for this, the Options Seller receives money called “Premium”.

Contracts need something for their agreement to be based upon. Ergo, the underlying Stock or Futures Contract.

The Option’s Strike Price

The Option’s Strike Price is another factor that goes into how an Option is priced. The Strike Price of an Option is the pre-agreed upon price that the Option’s worth is tied to. It is separate from the Underlying Stock or Future’s price.

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Strike Price and Moneyness

There are 3 states that an Option’s Strike Price can exist in:

  • In-The-Money (ITM)
    • If it’s a Call Option
      • The Option has a Strike Price that’s lower than the Underlying Stock/Future’s Price
    • If it’s a Put Option
      • The Option has a Strike Price that’s higher than the Underlying Stock/Future’s Price
  • At-The-Money (ATM)
    • The closest Option to the current Underlying Stock/Future’s Price on both the Call and Put side
  • Out-Of-The-Money (OTM)
    • The opposite of ITM
    • If it’s a Call Option
      • The Option has a Strike Price that’s higher than the Underlying Stock/Future’s Price
    • If it’s a Put Option
      • The Option has a Strike Price that’s lower than the Underlying Stock/Future’s Price

Depending upon how far ITM or OTM an Option is (its “Moneyness”), will have an effect on its value.

The further OTM an Option is, the cheaper and less valuable it is. It will have zero Intrinsic Value.

While OTM Options might seem attractive, especially to newer Options traders, because they’re cheaper, buying them is like flushing money down the toilet. The odds are very slim that they become worth more than what you paid.

The deeper ITM an Option is, the more expensive and more valuable it is. It will have less Extrinsic Value, and higher Intrinsic Value.

The Premium of an Option is the price an Option’s Buyer pays on top of the Intrinsic Value. OTM Options have no Intrinsic Value, so their price is completely Premium.

An ITM Option will still have some Extrinsic Value (In other words, “Premium”), but it makes up for it by actually being worth something at its Expiration.

Time Value

You may have heard that Options are depreciating assets. Time Value is the reason behind this. You see, as an Option nears its expiration date (all contracts expire at some point) it becomes less and less valuable.

As an Option nears its expiration the price decreases. Once an Option is within the 30-40 day window of expiry, the rate at which their value decreases speeds up exponentially.

In other words, the farther out in time that an Option is from its expiration, the more Premium it has. As the Option nears expiration, Theta Decay works its magic and causes the price of the Option to decay faster and faster.

Volatility

Volatility is one of the more elusive aspects of Options pricing. We’re going to focus on 2 aspects on Volatility in this article: Implied Volatility (IV) and Historical Volatility (HV). By the way, when people talk about Volatility in the trading world, it’s an equivalent word for movement. 

If what you’re trading doesn’t move, you don’t make any money.

Unless you’re selling Options. Even then, Volatility is important.

Historical Volatility

Historical Volatility, as the name implies, refers to the historical volatility of an underlying. In other words, it is the amount of Volatility that actually took place in the past. While past performance is never indicative of future results, knowing the Historical Volatility can at least provide us some context about the current Volatility of an Underlying.

Implied Volatility

Implied Volatility (IV) is the measurement of how much an underlying is expected to move over a given period of time. In other words, it is the future prediction of how much a Stock or Futures Contract is going to move.

Implied Volatility has a big impact on the price of an Option. The higher the Implied Volatility of an Option, or its underlying, the higher the Premium is going to be. The higher the Premium, the higher price you are going to pay for an Option. Conversely, the higher the Premium, the more money you can make as an Options Seller on the same trade.

Implied Volatility tends to be mean reverting, so Options Sellers like to wait until Implied Volatility is in a certain percentile, before selling Options. This way they can take advantage of Time Decay (Theta Decay), and a decrease in Implied Volatility from its higher levels. This reversion in Implied Volatility is also known as Volatility Crush.

Implied Volatility can be difficult to wrap your mind around at first, but it is extremely important to understand. It can just seem like this intangible, allusive concept at first. However, it’s one of the most important and applicable concepts in trading.

I cannot stress that enough.

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Even if you are not an Options trader, or have no plans to trade Options in the future, having an understanding of Implied Volatility can help you gauge your expectations of a Stock’s future price movement.

For instance, if you are a Day/Swing Trader, having an understanding of Implied Volatility will help you to know if a trade has run its course. It will help you understand if you are at a price extreme given the expected range, and the actual range that has taken place.

Meaning that if the expected move for today in the E-Mini S&P Futures is expected to be 15 points, and after lunch we’re at 18 points on the day, then there is a pretty decent probability that the Futures are going to back off a bit.

Tell Us What You Think

Anyway, I hope this overview of the different factors that go into an Options price helped you have a better understanding of how Options work and trade the way they do. If you would like to continue the conversation further, or have some questions, feel free to drop us a comment below.

Thanks, have a great day!