One of the options trading basics that you need to understand when you begin to trade stock options is options pricing. It helps to know why you are paying what you are paying for a particular options contract. It can go a long way in determining whether you want to buy the option contract or whether you want to be a seller of the option contract.
Option pricing is based on something call the Black-Scholes pricing model. It is too complicated to go into but I thought you might like to know that piece of information. Now let’s get to the components that go into the option pricing model so that you understand the options trading basics a little better.
The pricing of an option is for the most part determined by three different things: 1) where option is trading in relation to the stock price, 2) how volatile is the underlying stock and 3) how long till the option expires.
An option either trades in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM). These terms are used to relate the strike price of the option to the price of the underlying stock. If stock ABC is trading at $25 per share and you hold either a 25 call or 25 put then you are said to be at-the-money. In other words, the stock is trading at the price of the option. Now if you owned a call with a strike price of 20 and the stock was still trading at $25, you would be in-the-money to the tune of $5. On the other hand a call with a strike price of 30 when the stock was trading at a price of $25 would be said to be out-of-the-money.
If you are trading options with call then you are in the money if the underlying stock is trading higher than your strike price. You are out-of-the-money if it is trading lower than you strike price. If you are in-the-money the option contract is said to have intrinsic value. In other words, in our example above (a strike price of 20 when the stock is at $25) the call option would have a value of at least $5. Therefore a call with a strike price of 20 would be priced higher than a call with a strike price of 25 and just the same the 25 would be priced higher than the 30. If you are at the money or out of the money the stock does not have any intrinsic value. So intrinsic value is the first component to option pricing.
By the way it works just the opposite for a put. Remember when you buy a put you are expecting the price of the stock to decline. Therefore, an in-the-money put option would be when the strike price is higher than the price that the stock is trading at. An out-of-the-money put option would be where the strike price is lower than the price that the stock is trading at.
The second component to price is the volatility of the stock. When you buy or sell an option a volatility component is built into the price. Stocks that are more volatile would cost more than those that are not. An option for a volatile $15 stock will cost more than an option for a non-volatile stock. The reason this is the case is because the stock has a chance to make larger gains (or losses) so they charge you for that. This could be called the volatility premium of your option.
The third factor that influences the price on an option is how long it is till expiration. Very simply put, the longer till expiration the more the option will cost. You pay more for the right to hold the option longer. If you somehow believed that a stock was going to make a move in the next two weeks based on news that should be released you wouldn’t want to buy options that were six months out. You would stick to a near expiration month so that you didn’t have to pay as much.
So in general, the intrinsic value of the option, the volatility premium and the time premium will be the main factors determining what you pay for an option.
Before I close I should cover one other options trading basics as it relates to options pricing. The price that you see listed for an option is not the same price that you will have removed from your account when you purchase. Remember that an option contract most often represents 100 shares of stock. So you need to multiply your option price by 100 to determine you actual cost (plus commissions, of course). An option trading at $2.55 will cost you $255 for each contract that you buy. If you bought 10 contracts your cost would be $2550.