Options are derivative financial instruments that give the buyer the right (but not the obligation) to buy or sell an underlying security, such as a stock, within a predetermined time period for a predetermined price, known as the strike price.
Investors like options because they allow the investor to bet on the price increase or decrease of a stock, without owning the stock itself. There are two main types of options: call options and put options. An investor who buys a call option buys the right to buy the option’s underlying asset. An investor who purchases a put option is buying the ability to sell the option’s underlying asset.
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How is an Option Price Determined?
The sellers of an option take many different factors into account to determine the price, or premium, of an option. The most widely known method for determining the value of an option is the Black-Scholes model. But other models – such as the binomial and trinomial options pricing models – are more commonly used to determine stock option prices.
All of those options pricing models are complex, but they all draw on a few primary factors that drive the investment value of an options contract:
• the market price of the stock that underlies the option
• the current intrinsic value of the option
• the time until the option expires
Market Price and Intrinsic Value
The first is easy to understand – it’s the price at which the underlying stock is trading. The second – the intrinsic value of the option – is the value of the option would be worth if sold at that moment. This only applies if the price of the underlying stock has moved to where the option is “in the money,” meaning the owner of the option would make a profit by exercising it.
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The time until expiration is more complex. It represents the possibility that an out-of-the-money option could eventually become profitable. This so-called time value reflects the amount of time an option has until it expires. It’s one part of an option’s value that only goes down – and which goes at an increasingly rapid rate as the options contract approaches expiration. As the expiration date gets closer, the underlying stock must make bigger moves for those price changes to make significant changes in stock options pricing.
That time value reflects the volatility of the underlying security, as well as the market’s expectation of that security’s future volatility. As a general rule, stocks with a history of high volatility underlie options that with a higher likelihood to be in-the-money at the time of their expiration.
Volatility, in many pricing models, is represented by beta, which is the volatility of a given stock versus the volatility of the overall market. And options on stocks with higher historic or expected volatility typically cost more than options contracts on stocks that have little reputation for dramatic price swings.
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What Are the Different Option Pricing Models?
There are several models that investors and day traders consider when figuring out how to price an option. Here’s a look at a few of the most common:
The Black-Scholes Merton (BSM) Model
The best-known options pricing method is the Black-Scholes model. The model consists of a mathematical formula that can be daunting for people without a math background. That’s why both institutional and retail investors employ online options calculators and analysis tools.
The economists who created the formula published their findings in 1973, and won the 1997 Nobel Prize in economics for this new method for arriving at the value of financial derivatives.
Also known as the Black-Scholes Merton (BSM) model, the Black-Scholes equation takes the following into account:
• the underlying stock’s price
• the option’s strike price
• current interest rates
• the option’s time to expiration
• the underlying stock’s volatility
In its pure form, the Black-Scholes model only works for European options, which investors can not exercise until their expiration date. The model doesn’t work for U.S. options, because U.S. options can be exercised before their expiration date.
The Binomial Option Pricing Model
The Binomial Option Pricing Model is less well-known outside of financial circles, but it’s more widely used. One reason it’s more popular than the Black-Scholes Model is that it can work for U.S. options. Invented in 1979, the binomial model reflects on a very simple assumption – that in any pricing scenario the premium will go one of two ways: up or down.
As a method for calculating an option’s value, the binomial pricing model uses the same basic data inputs as other models, with the ability to update the equation as new information emerges. In comparison with other models, the binomial option pricing model is very simple at first, but it becomes more complex as investors take multiple time periods into account. For a U.S. option, which the owner can exercise at any point before it expires, traders often use the binomial model to decide when to exercise the option.
By using the binomial option pricing model with multiple periods of time, the trader has the advantage of being able to better visualize the change in the price of the underlying asset over time, and then evaluate the option at each point in time. It also allows the trader to update those multi-period equations based on each day’s price movements, and emerging market news.
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The Trinomial Option Pricing Model
The trinomial option pricing model is similar to the binomial model but it allows for three possible outcomes for an option’s underlying asset within a given period. Its value can go up, go down, or stay the same. As they do with the binomial model, traders recalculate the trinomial pricing model over the course of an option’s life, as the factors that drive the option’s price change, and as new information comes to light.
Its simplicity and acknowledgement of a static price possibility makes it more widely used than the binomial option pricing model. When pricing exotic options, or any complex option with features that make it harder to calculate than the common calls and puts on an exchange, many investors favor the trinomial model as a more stable and accurate way of understanding what the price of the option should be.
Understanding how options pricing works is important, whether you’re interested in trading options or not. However, you can also build a more straightforward portfolio that does not use options at all.
A great way to get started is by opening a brokerage account on the SoFi Invest investing platform. SoFi Invest offers an active investing solution that allows you to choose stocks and ETFs without paying SoFi commissions. SoFi Invest also offers an automated investing solution that invests your money for you based on your goals and risk.
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