Getting Started in Options Trading, Part Two - How Option Pricing Works

Posted by jbrumley on February 3, 2017 8:17 PM

Ready to get started trading options?  If you're brand new to option-trading and don't yet know the difference between a put and a call, then be sure to read through the first part of this two-part lesson before proceeding.  The second part you're reading now looks at a couple of the nuances and oddities in how options are priced in the real world.  Superficially/mathematically option prices don't make sense until you understand there are two components an option price reflects.

Those two components are an option's intrinsic value, and its time value.

The intrinsic value is exactly what it sounds like it would be - the mathematical value of the difference between the strike price of an option and the underlying stock's present price.  Let's work through an example.

As of right now, Procter & Gamble (PG) shares are trading at a price of $87.50.  Let's assume we think PG shares are moving higher and we want to buy calls.  Since Procter & Gamble shares are widely held and one of the most frequently-traded stocks, there are a variety of choices of strike prices.  For the purpose of this exercise, we'll say we want to buy the 85 calls that expire 30 days from now.  These calls are inherently worth $2.50 per contract (100 shares x $2.50 = $250 per contract), as they give us the right to buy shares of PG the $85.00 apiece, which we could simultaneously sell at a price of $87.50 each....  $87.50 -$85.00 = $2.50.  That's the intrinsic value built into (at a minimum) the price of that particular call option.

If you actually wanted to buy that call, however, you have to pay a price of about $2.90 (or $290 for one contract).  That additional $40.00 is called time value, or the premium you would have to pay in order to make such a speculation.

The time value can and does change as expiration dates change.  The further out your expiration date, the more time value you'll have to pay to buy an option.  Of course, the more time you're able to hold an option, the greater opportunity for gain you have. [That's why you would pay any premium in the first place.]

Let's work through another example, this time using a put option.  

Visa (V) is our Guinea pig.  We think Visa shares are poised to move lower from their current price of $86.08.  But, we think that downward move is going to be short-lived, so we don't have to buy a great deal of time.  We'll choose the puts with a strike price of $88.00 that expire in just 14 days.  For this option we would have to pay a price of $2.25 (or $225 for one contract).  The intrinsic value again is simply the difference between the stock's current price of $86.08 and the strike price of $88.00.  That's $1.94, or $194 for one contract.  The difference between the intrinsic value and the put option's actual price -- the $31.00 difference -- is the time value or premium you would have to pay to make the trade.

As was the case with the call option, the further out the expiration date is, the more premium you will pay above and beyond the option's intrinsic value.

The time value of option pricing is not standardized or set by a market maker.  It is set by the same supply-and-demand forces that pressure the value of a stock higher or lower - those traders that are buying or selling options simply demand their price.  In some of the more advanced option strategies though, the time value or premium can be used to your advantage.

It must also be explained that in the above examples we assumed only one contract was being traded.  Obviously you can buy more than one contract at a time.  Although this will up your costs and your committed capital, it will proportionally expand your potential upside.

One last note on the matter of how options are priced and what you'll see when you start trading them.  There are two figures for most option quotes - the bid price, and the ask price.  The ask price is what you'll pay when you buy a call or a put.  The bid price is what you'll receive in return when you sell that call or put.  The difference between the two numbers is called the spread.  For most of the more-traded stocks, option spreads are rather narrow...  only a few pennies.  For less-liquid names, the spreads may widen a bit.

Generally speaking you'd want to stick with names that are more liquid and have smaller spreads, just so you're not entering a new position with something of a disadvantage.  Still, for traders looking for significant moves from the underlying stock, the size of the spread is negligible in most cases.

If you've read everything above as well as the first part of this "Getting Started" overview, you're almost ready to get going with option-trading.  There's more to learn, but you've got enough the basics.  That said, we strongly encourage you to do what is called paper-trading first, before committing any real money to your option trades.  Paper-trading it's just a hypothetical portfolio you manage as a way of learning the process and putting your skills and knowledge to the test. This will let you figure out the nuances of choosing strike price is and expiration dates in a real-world setting.

Though not absolutely necessary to get started, it might also be wise to familiarize yourself with the so-called "Greeks" of option trading, since they can impact the time value of options, and even impact how those premiums change.  For more on the Greeks, learn about delta here, theta here, gamma here, and vega here.

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