Influences on a Stock Option's Value

What Traders Need to Know About an Equity Option's Premium

Aug 26, 2008

As with anything related to capital markets, sometimes a stock option is priced at what it's worth, and sometimes not. Some basic math can show a trader their true cost.

Even those traders who are new to options will have noticed an option’s price doesn’t always move consistently with the underlying stock. While there’s not always a lot that can be done about it, getting a grip on the forces causing that inconsistency can make the disparity easier to deal with.

Basics

As a refresher, an option has four components – the underlying stock, the expiration date, the strike price, and whether or not it’s a put (bearish) or call (bullish) option.

For illustrative purposes of an option pricing model, IBM’s October 115 calls (IBMJC) are a good example. When the stock is trading at $125 per share, and this contract offers its owner the right to buy IBM shares at $115, the option’s intrinsic value is $10….the difference between the strike price and the underlying price.

In reality though, if IBM was trading near $125, this option would be priced anywhere from above $10, to possibly as much $20 (if not higher).

The difference between the intrinsic value and the option’s actual price is called ‘time value’, or ‘speculative value’. Aside from being the more ambiguous price component, its inconsistency is also a source of frustration for many option traders.

There are three primary drivers behind how much time value is packaged into an option’s price.

Time Until Expiration

In the example above, when IBM is trading at $122.50 and the October options have two months until they expire, the October 115 calls are worth $9.90. That’s $7.50 worth of intrinsic value and $2.40 worth of time value.

The January 115 calls, however – which would be ‘alive’ for three months beyond October – are priced at $12.80. That’s $7.50 worth of intrinsic value, and $5.30 worth of time value.

Why the difference? The more time IBM has, the more it might move (and the bigger the potential gain on the option). Current owners of those January 115 calls know this, and require a slightly higher premium… reflective of that potentially bigger opportunity.

Volatility of the Underlying Stock

Since a volatile stock is more apt to move well beyond (above or below) a strike price, it might offer an owner of an option a better chance – or at least a window of opportunity – to make a significant profit. Therefore, they are more attractive to option traders, who are willing to pay a slightly higher price for higher odds of profit.

An involatile stock that doesn’t move very far or very fast isn’t apt to give option owners a great chance at a big gain. Those options don’t seem as attractive to option traders, and therefore they can’t command the same degree of time value.

Interest Rates

In general, an increase in interest rates should mean an increase in call prices and a decrease in put prices. And, vice versa. This theory isn’t always right though.

Even so, this is only a minor factor at best when it comes to an option’s time premium.

Again, once a trader owns an option, none of these three factors can be controlled. However, knowing how they may influence an option’s price will at least help a trader assess an option trade’s progress – or lack thereof.

The copyright of the article Influences on a Stock Option's Value in Options Investing is owned by James Brumley. Permission to republish Influences on a Stock Option's Value in print or online must be granted by the author in writing.