Options Pricing

Much has been said about trading options, especially its advantages and pitfalls. Some don't mind jumping in armed with their own research, confident that the market will move in their favour. Others prefer to step away leave the speculations to the risk takers. One of its most talked about features is it enables traders to earn in bullish, bearish and even neutral market conditions. More importantly it provides opportunities to earn big returns at a fraction of the cost of the underlying shares. We are going to look into what influences the price of an option.

Options Pricing Terminology:

• In the money (ITM) – share price is above the strike price of a call or put
• Out of the money (OTM) – share price is below the strike price of a call or put
• At the money (ATM) – share price is the same or close to the strike price

Premium

It is the only element not specified by the ASX because it's influenced by different factors. Volatility of the underlying stock price, option's exercise price and expiry date all have a bearing on its value. The premium is composed of two parts, the intrinsic value and the time value.

Intrinsic Value

It is the difference between the current share price and your option's exercise price. An option has intrinsic value if, when you exercise the option, leads you to buy or sell the shares at a price higher than its current price.

Call options have intrinsic value if the underlying share price is above the exercise price. On the other hand, put options have intrinsic value if the underlying share price is below the exercise price.

Time Value

It is the part of the premium which is over and above the intrinsic value. Before the expiry date the option will trade for more than its intrinsic value. When your option is OTM or ATM, it has no intrinsic value and is entirely made up of time value. Options with the same expiry may have a different time value. There is a relationship between your option's strike price and its time value.

These are the components that you have to look into so you can determine if your option will be valuable or not. Of course, the market can still change and it may not move in your favour, but some research can help you along the way.