The Variables That Drive a Stock Option's Value

Several factors affect the price of publicly traded stock options

Several factors affect the price of publicly traded stock options

Stock options give you the chance to speculate on the direction of a company's stock without actually investing in the shares. The option gives you the right to buy or sell the stock at a certain price, up to a future expiration date. Options move with the price of the stock, but are generally more volatile and risky than buying the underlying investment. Consider several option price-moving factors when you're researching these investments.

Stock Price

The most important factor in option price is the price of the underlying stock. Call options on Microsoft, for example, give you the right to buy the stock at a fixed "strike price," and so rise in "intrinsic" value whenever the price of Microsoft stock rises. Put options on the same shares will rise in value when the stock falls, because these options give you the right to sell the stock at a certain price. Note that each option contract actually represents 100 shares of stock, so you must multiply the quoted option price by 100 when evaluating how much capital you'll need.

Time

Another critical factor in option pricing is time value. As the calendar moves toward the expiration date, the option gradually loses time value, even as intrinsic value may rise and fall. An option with several months to go before expiration has a better chance to gain in value than an option that will expire in just a few weeks or days. Professional option speculators use a mathematical formula to calculate the intrinsic and time value of options; as a casual investor, it's just important to remember that longer-term options are naturally going to be worth more. Time value depreciates most rapidly in the days just before expiration.

Market Factors

Supply and demand represents another critical factor, as with any investment that is publicly traded. This factor depends largely on investor sentiment. If option traders are anticipating good news from Apple, the call options for this stock are going to be in higher demand, and their price will rise, over and above the intrinsic and time values. In addition, stock investors who don't normally trade options may be entering the option market if they feel the short-term prospects for a particular stock are good -- or bad.

Stock Volatility

Options based on volatile stocks are generally worth more than options on relatively dormant shares that don't change greatly in price from day to day. If a stock's price moves rapidly in either direction, the option prices move concurrently with a magnified rate of change. The faster prices move, the higher the potential profit and return on the investment (and, of course, the greater the risk of losing your entire stake). It's not unusual for options to double or triple in price in just a few days when a stock makes a major move -- and option traders will pay a higher premium for that potential windfall.

 

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