There are three major factors that affect
the price of an option:
the underlying security.
The strike price is the price at which an
option can be exercised. Using the example of a stock index option, it
is the index value at which an buyer can buy or sell shares of the
underlying stock index. An option's intrinsic value is defined as the
difference between the market price of the underlying security and the
strike price of the option.
A call option has an intrinsic value if its strike price is lower than
the current market price of the underlying security. In this case, the
option is said to be “in-the-money”. Conversely, if the market price of
the underlying security is below the strike price of the call option,
the option is considered “out-of-the-money”. Finally, if the current
market price of the underlying security is equal to the strike price of
the call option, the option is said to be “at-the-money”.
The reverse is true for put options. A put option is “in-the-money” (has
intrinsic value) if its strike price is higher than the market price of
the underlying security. It is “out-of-the-money” if its strike price is
lower than the market price of the underlying security. Finally, if
market and strike prices are equal, the put is said to be “at-the
In-the-money options are always are more expensive than out-of-the-money
options, because the risk of losing the option premium is higher for
out-of-the-money options. The higher an option's intrinsic value, the
higher its price, because a higher price means lower risk for the buyer.
Time value - is one of the major
components affecting an option's current price). Time value is more
difficult to determine than intrinsic value. Time value derives from the
buyer's willingness to pay a premium for a possible future increase in
the value of an underlying security within the time period leading up to
the option's expiration.. If the underlying security does indeed
increase in value before the option expires, the (call) option will
become more highly valued.
Basically, the more time that remains until an option expires, the
higher its time value. But the buyer of an option must also pay a
greater price for a higher time value, because the seller of the option
takes on a higher degree of risk - the more time is left until
expiration, the more an option can (theoretically) go in-the-money,
which drives up its market value .
Volatility is defined as the degree to
which an underlying security moves (up or down) over a period of time.
The volatility risk of an options portfolio thus accounts for the
unpredictable changes that may occur in the underlying asset during the
life of the option.
Volatility measures the rate of (price) change of an underlying
instrument. The higher that volatility, the more likely it is that an
option will become profitable before it expires. That is why volatility
is a primary determinant of options valuation.
Volatility and time value have a tremendous
impact on the price of an option. For an options buyer, time is the enemy
that increasingly erodes the value of an option and increases the risk of
losing the entire premium.
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