Options Pricing

If you're new to options trading it's recommended that you become fully aware of how options are priced and what the various terms actually mean. It's all too easy to lose money when trading options at the best of times so you should certainly have a firm grasp of options pricing before you even attempt your first trade.

Let's first of all discuss the strike price (or exercise price). This is basically the price that the share price has to go above (in the case of a call) or below (in the case of a put) in order for your option to be in the money and therefore profitable. If it goes beyond this strike price in your favour then the option can be exercised for a profit before the expiry date but if it falls back below this level at the date of expiry then the option will expire worthless and you will have lost the amount that you paid for the option.

Each options contract is usually equivalent to 100 shares, at least in the United States, and the cost of the option contract is derived by multiplying 100 by the option premium. The price of each option consists of a number of factors but the most important ones are the intrinsic value, time value and volatility.

An option has intrinsic value if it is currently in the money, ie above the strike price for a call and below the strike price for a put, so the greater it is in the money the higher the intrinsic value and therefore the higher the option premium.

The other important factors are the time to expiry and the current volatility of the underlying security. For example an option that is well out of the money and has just a few days left until it expires will be extremely cheap because it is unlikely to get into the money within that time. Similarly if a particular stock is trading well out of the money and is not very volatile then this too will also be priced very cheaply because it barely moves. So basically the farther out of the money and the less volatile the security, the cheaper the option will be in general.

So to sum up this article on options pricing, the price of an option is basically dependent on the intrinsic value plus the time value, as well as the volatility of the underlying security.