Stock Option pricing is determined by a couple variables. You must understand these to trade stock options. This series must all be read together so check out the first post here. Now, let’s see what we can learn from this information…
The Difference between Strike Price and Current Market Price for a Stock Option
You’ll notice that even though the strike price of these options are only $2 away from each other each, the value of the options are each greater or lower by a factor of 10! This shows you what a big difference the distance away from the current price can make to an option’s price (particularly when the expiration date is close as it is in this case.)
The price which is “in the money” ($26) is trading for a price that is close to what you would get if you add the price of the option to the current price of the stock. This is often the case.
The price of the stock option which is “near the money” ($28) is about 1/10th of the price of the first option. It’s currently out of the money and there are only a couple weeks until this option expires. If the stock price doesn’t move over the next couple weeks, this option will expire worthless.
The $30 Strike Price Option is trading well out of the money. The market would have to make a major move in these couple of weeks for that price to be hit. Because of this, the option is trading at only around 1 cent. If you were to buy this option and the stock moved to $31 before Dec 18th, you would make 100 times your money! Of course, this is extremely unlikely to happen which is why the option is priced so low.
We chose these three to illustrate because it just so happened that each of these prices varied by a factor of 10. There is nothing magical about the factor of 10 and it’s not something you should look for in options, but we thought this really illustrated well the huge differences in option prices.
Time Till Expiration
Now, let’s look at an option that has an expiration date further out into the future…
Calls for Jan 22 2011.
Last Change Bid Ask Volume Open Int Strike
0.11 -0.03 0.11 0.12 906 250,667 30
You can see that this stock option has the same $30 strike price as one of the options we showed which expired on Dec 18th which last sold for $.01. This option which is a month further from expiring last sold for 11 times that amount ($.11). This demonstrates the added value which time brings to an option. If the price of Microsoft doesn’t move much over the next month this option price will probably drop down to about the same as what we currently see displayed for the December option.
Remember that if you agree to buy a Call Option for $.11, you are actually going to send in $11 (per option that you bought) because the option represents 100 shares. If you sold the Call Option, you would be paid $11 per option that you sold.
Volatility in the Market
We can’t illustrate the affects of volatility in the market on option prices for you’re here in the same way we have been demonstrating the other factors which influence price. Volatilty changes over time and everything presented here was at the same moment in time. However, you should know that volatility was extremely low at this point in time. Later when volatility is higher, you could expect that similar options would be trading at higher prices.
This is actually definitional because volatility (the VIX index for instance) is determined by how high or low option prices are trading. When the market is bouncing radically and particularly if it has an overall downward falling direction, options prices across the board will be higher. Investors will be more willing to pay more for options as a hedge, or protection, against their positions.
Volatility is not a factor that will influence you to choose one option over another in a similar options chain. (For instance, it would have no impact on the decision of whether to buy the $28 strike price option or the $30 option.) However, it might influence whether or not you buy or sell an option at all. If you’re selling options and volatility is extremely low, this means that you are not going to be paid very much for the risk that you are accepting. This might cause you to not enter the trade. You might wait until the trade looks to have a better risk/reward profile.
This is Post 4 of a new series on stock options which we’ll be revisiting every few days. You can find the first few parts at the following links: Pt 1, Pt 2, & Pt 3. You can check out the series we just finished on professional money management and funds by following these links: Pt 1, Pt 2, Pt 3, Pt 4, Pt 5, & Pt 6.