Options Pricing - A Simple View

Options pricing is a complex science. Its won a nobel prize for the authors of a pricing model. However, it can be broken down into 2 components: Inherent/Intrinsic Value of the option + "Premium": Option Value = (Value of Option) + Premium

The first component, Value of Option, is easy. If its "in the money", its the difference between the strike price and the current price of the stock. If its "out of money", its zero: at that moment, the option has no "face value." For instance, if you buy a call option for a stock trading at $25 with a strike of $20, this option has a $5 inherent value. You could excercise this call option and immediately have a $5 gain. On the other hand, a call with a strike of $30 on the same stock woudl have an inherent value of $0, you can't excercise this option (or wouldn't want to). Puts work in the opposite direction.

Premium is the component that is far more complex. Premium can be broken down into other factors: time value of the option (expiration), volatility of the underlying stock, and many other factors. Namely, for the same stock, the premium will be higher for options that expire further out than ones that expire sooner. Now, take an option on a stock with low volatility versus one with high volatility: the premium will generally be higher for a highly volatile stock than one that is less volatile, holding other factors constant. Look at the option chain for Google versus IBM. For options with the same expiration and similar inherent value, the prices will be much different.

With options trading, the bottom line is what the market is willing to pay for an option. I'm not really well-read in terms of option theory as it applies to trading, so some of my ideas that I have gathered from practical experience may not be original. One thing I take into account when I look at an option chain and deciding which strikes to buy is taking into account how far out of the money an option is. Let's take an example.

Example 1: Stock XYZ is currently trading at $25. I look at the options chain for calls and focus on 3 in particular (with same expirations):

Strike Price Option Price Premium "Virtual" Premium
$20 $6.25 $1.25 $1.25
$25 $2.75 $2.75 $2.75
$30 $1.00 $1.00 $6.00

Let's check out what the "premium" I'm paying for these options. The $20 strikes, I see its $5 in the money and thus has a $5 inherent value. The option price is $6.25. I see my premium is $1.25. You can see this in the table above. I've laid out the premium according to the simple formula I presented. However, I consider a "virtual" premium as well. As you can see, this "virtual" premium is the same for at the money and in the money options. However, for out of the money calls, it is different, namely is higher than the other premium. I use this number because I consider it a "hidden" premium. With the $30 strikes, I am $5 out of the money. In other words, I am giving up $5 to the writer of this contract. Its a hidden cost. It would be akin to buying a new car versus an old car in need of repairs. The new car may be more expensive but you won't need to put any work into it (thereotically!). However, the old car may have engine problems, transmission problems, etc. You may need to pump $5,000 or $10,000 into the car to get it in working order. So its a hidden cost. I apply the same principle to this option. You may not be outlaying it in cash up front, but you do "pay for it" which I will discuss next.

So why is this important? Because this will affect how well your trade goes. Generally speaking, the more premium you pay, the less it will move with the underlying stock's price. You'll see this on an options chain. Take a look at list of strikes for stock. Say the stock we used as an example shot up $3 points right after we purchased the option. Options generally do not track poitn for point in movement, but rather a percentage of the movement. And you'll see that optiosn with higher premiums have a worse movement as a percentage of price movement of the stock. So, for a 3 point gain, we'd probably see the $20 strikes move about 2.5 points up. The $25 strikes might move up a point. And the $30 strikes might only move $0.50. Looking at the same options chain, the best gains are seen in more "in the money" options. The smallest gains occurs as you move more to "out of the money." Likewise, look at an option with the same strike and expiration but a different underlying stock. The option with the higher premium won't move as nicely. For instance, let's look at IBM vs. Google. Google is far more volatile and hence their options and much more pricey than IBM. Say both IBM and Google move up 3 points. IBM's call options will track much, much better than Googles.

This is a very simplistic overview of looking at options. When I decide which strikes to buy for a particular option, I take into account the "virtual" premium. In my opinion, even though you aren't paying for it in cash, with out of money options you are giving the amount it is out of the money away to the writer of the contract.

So why is this? One might think that the "Premium" on a given option chain for the same stock with same expirations should be the same. I'm sure there are books and such that explain this, but I break it down to simply demand. I beleive as the option gets more in the money, its gets far more expensive because of its increased inherent value and thus has a smaller market. Most people trading options do so for the increased leverage. If they are paying half the value of the stock on an option, they may figure they'd be better off buying the stock itself. And there are options so far out of the money that it more than likely won't hit that price any time soon. I chalk it up to lotto type mentality. The options are cheap, might make a bet on them and make a huge return percentage wise if something does happen.

So how do I apply this on trading? I generally stay away from options with abnormally high premiums. Google for instance. Also, it depends on how much cash you have to trade with. I've found that options that are $4-$6 in the money work best for me. I might outlay $5,000-$7,000 for a trade, but they will move well with the stock price. Anything more than that, I just don't want to lay out that much cash for a trade. If you do buy out of the money options, you are looking for a quick spike and to get out as soon as possible (aside from betting on good earnings which could boost stock up tremendously). Out of money options are hard to get a good "raw return" on. Percentage wise, you may do very well, but for a given number of contracts, the dollar amounts will be smaller. You could get much more leverage for a given dollar amount on more out of the money option, however, it gets riskier and as discussed, doesn't move as well. If you have the cash, I prefer less leverage and "in the money" options versue more leverage and "out of the money" options. Your rate of return may not be as great, but raw dollar amounts will be better in general (unless the stock really skyrockets, or dips, depending on your position). But trading on smaller intraday fluctuations is easier with in the money options.

I will discuss more in detail as time goes on. Again, I'm nto a professional and am simply basing opinions on my observations, so nobody slam me too hard. I have some analysis tools that I've developed to help me price options, look for how they move with the stock price and other factors to help me pick a trade. But overall, this is how I do it.