Option Valuation
The competitive bids and offers in the marketplace affect the option premium. The price of an option is a function of supply and demand. Stronger demand will drive the option price up.
An option premium is made up of two separate components:
- Intrinsic value: Intrinsic value of an option is based on the difference between its exercise price and the current price of the underlying asset. Intrinsic value is part of the premium which could be realized if the option were exercised. A put option has an intrinsic value only if the asset price is above the exercise price. A put option has an intrinsic value only if the asset price is below the exercise price.
- Time value: Time value represents the value placed on the possibility that the option may become profitable to exercise at some time before the expiry date. The entire premium of at-the-money options and out-of-the-money options represent time value. In-the-money options have time value in addition to intrinsic value. Time value declines over time as an option nears expiry. Expired option has zero time value. Hence the longer the time until the expiration date, the higher an option’s time value premium.
Factors that Affect the Value of an Option
The following factors affect the time value of an option:
Price of the Underlying Asset
The price of the underlying asset is the most important factor in determining the option premium.
Exercise Price of the Option
The premium for an option which is deeply out-of-the-money will be less than an option which is slightly out-of-the-money.
Time to Expiry
All other thing beings equal, the greater the time to the expiry date, the higher the time value of the option. Expired option has zero time value.
Market Volatility
The volatility of the underlying asset plays an important role in the valuation of an option. In general, the more volatile the market, the higher will be the premiums for option in that market.
Interest Rates
If there is a high cost of holding the asset due to high interest rates, there will be more demand for call options on that asset. This is because the purchase of an call option involves a far smaller cash outlay than buying the asset outright.
Cash Dividends
Any monetary return earned by holding the underlying asset will have effect on the price of an option. For example, dividends of an equity stock.
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Filed under All About Options, Option Basics by on Apr 16th, 2010. 