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April 21, 2011

Option Pricing: How does it work?

Option Pricing MazeA friend of mine thought Google stock (GOOG) was going down after their earnings announcement. He knew he wanted to buy puts to take advantage of the anticipated downward movement in the stock price. He picked an option strike well below the current price of the stock. Google did move down after the announcement but not far enough. His puts expired worthless the next day. My friend didn’t understand how options are priced and how to use that information to pick a more appropriate strike for his put.

Let’s discuss the two components of an option’s price and the primary factors that influence them.

1. Intrinsic Value or real value
2. Extrinsic Value or time value
3. Factors that change Extrinsic Value

Intrinsic Value or real value

Intrinsic value of an option is the amount of real value the option has if it were exercised. This is the amount the option is in-the-money. For calls, it is the strike price minus the stock price. For puts, it is the stock price minus the strike price. The number is always positive. If an option is out-of-the money, the intrinsic value is always zero.

For example, if you have a stock trading at $105 and your Call strike is $100, the option has a real value of $105 – $100 = $5. If there is any time left before the option expires, the option will be priced higher than this difference in strike prices.

Extrinsic Value or time value

An option with any time left before it expires will have a higher price than its intrinsic value. The difference between the option price and the intrinsic value is called extrinsic value. Other names for extrinsic value are time value, time premium or fluff. This premium is what the option seller hopes to keep for his profit. The option buyer will slowly lose this time premium as the option gets closer to expiration. All options at expiration have zero extrinsic value. An option at expiration is either worth something or it expires worthless. Because traders prefer out-of-the money options, more options expire worthless each expiration cycle than options that expire with real (intrinsic) value.

Factors that change Extrinsic Value

The option pricing model includes variables for time to expiration, volatility, dividends and interest. Because we usually are only in the market a few weeks, we can assume interest and dividends don’t play a large role in the option prices we trade. That leaves two primary factors that influence option prices:

1. Time to expiration
2. Volatility

The more time there is to expiration, the more time premium an option has. Options with more time premium are more sensitive to volatility changes. Any time spread should consider the effects of volatility changing. This is especially true for long term options, or LEAPS.

The volatility of an option is calculated from the option pricing model. All of the other factors are known, including price. Volatility is calculated and displayed as implied volatility. The price of the option implies a specific volatility. Option analytic software does this calculation for you for each option. Don’t try to calculate it by hand. You will notice that different software arrives at slightly different implied volatility values. These differences are due to different assumptions and using different inputs into different option pricing models. Stick with the same software so you are consistent.

Isn’t knowing the factors that effect extrinsic value a waste of time?

Not really. You know that options lose value as they get closer to expiration and that volatility affects the price of options. My friend who bought Google puts should have purchased puts with more time to expiration. Google releases earnings data after the market closes, the day before option expiration. I think they do it on purpose. Because options lose all time premium the following day, my friend would have been much better off purchasing an option with 30 days until expiration.

Volatility has more influence on longer term options. If you want to buy longer term options, make sure you buy them while volatility is low so you don’t pay for too much time premium.

Understanding option pricing isn’t difficult

Intrinsic value of an option is a simple difference between the strike price and stock price. Extrinsic value has many ingredients that go into it. If you are trading long term options, interest and dividends are more important. Implied volatility and time to expiration are the most important variables. Be aware of the factors that influence time premium when you trade.

Here’s your homework

Look at an option chain and calculate the amount of time premium for each at-the-money call and put for each of the next four to six expiration cycles. Compare the difference in time premium and notice how slowly it decays at first and then accelerates as you get close to expiration. For extra credit, look at options several strikes in and out-of-the-money and compare the decay to the at-the-money option.

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Tom Nunamaker

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