How to Price Options on Stocks
It would be difficult for the average person to price options without a strong understanding of the expectations for the underlying stock and the possible variations in stock prices generally. It is easier, however, to understand the main determinants of stock option pricing. Because most investors use the same general Black-Scholes model of option pricing, there is not much variation in the option pricing today.
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Instructions
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Think of option pricing as the function of three important variables: time, premium and volatility. These are values that vary geometrically and under constantly changing circumstances. Because nearly all institutional and sophisticated investors use variations on these variables options, generally trade at prices very close to their theoretical calculated values.
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Compute the price difference at which the option may be exercised and the current market price. Then compare this price to the option's market value. The difference is the premium of the option. For example, if a stock is at 50 and the option can be exercised at 45, there is an intrinsic or real value of 5 points in the option. If the option is trading at 7, subtract the intrinsic value of 5. The option is trading with a 2-point premium.
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Understand that the longer the time to the option's expiration, the more valuable the option is. Time creates option premiums. Time values decay so that just before option expiration, the option is trading very close to the difference between the strike price and the current market price of the option.
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Understand that trading volatility is a function of current interest rates and a measure of the daily range of a stock's price. In times of great uncertainty volatility increases. Because options can be exercised at any time prior to the exercise date, there is always an inherent volatility greater than that of the underlying stock. Generally, a stock that varies 3 percent a day on average will have a higher premium (almost double) of a stock with a 1 percent daily volatility.
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Use an option pricing calculator to compute option volatility. There are many option pricing formulas based on the work of Nobel Prize winner Robert Merton and the creators of the Black-Scholes theorem. Important inputs are the assumption of the current level of competing interest rates and the length of time used as a sampling of volatility. Time to expiration is easily calculated, as is the option premium.
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Tips & Warnings
With practice, most traders can estimate option prices.
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