Stock options engage the obligation or right to sell or buy a stock at a set price within a set time period. There are two categories: put and call options. People who have been paying some attention to options probably have become aware that a price of option does not move dependably from the underlying stock. Although there is not much that can be done to it, being aware of the causes leading to that discrepancy can make it easier to sort out.
As a reminder: an option has four factors â the underlying stock, the strike price, the expiration date and the nature of option (put or call, bearish or bullish).
For the purpose of illustration of a model to option pricing, when the underlying stock is trading at $100 per one share, and such contract grants its owner the privilege to buy subject shares at $90, the intrinsic value of the option is $10 (the margin between the underlying price and the strike price.
Actually though, if a stock was trading close to $100, said option would be valued somewhere above $10, to even as much $25.
The margin between the actual price of the option and the intrinsic value is named "time value" ("speculative value"). Apart from being the more equivocal price factor, its discrepancy is a source of disappointment for numerous option traders as well.
Below stated are three main drivers behind the options value.
Underlying Stock Volatility
As a high volatility stock is more disposed to move far above or below the strike price, it could provide an option owner a better possibility (or as a minimum a window of opportunity) to make a noteworthy profit. Consequently, they are more appealing to option traders, who want to forfeit a somewhat higher price for higher profit chances.
A less volatile underlying stock that does not move so fast or far is not disposed to give an owner of the option a decent chance of good profit. Such options do not appear as appealing to option traders, and consequently they cannot guarantee the same time value level.
Time Left Until Expiration
In the case above, when the underlying stock is trading at $102.30 and the previous month options have two months until expiration, the previous month $90 call options are valued at $9.70. That is $2.20 worth of time value and $7.50 worth of intrinsic value.
The two month after $90 call options, on the other hand â which would be effective for three months since issue â are valued at $12.60. That is $5.10 worth of time value and $7.50 worth of intrinsic value.
What is the reason for the difference? The more time underlying stock has, the more it can move - so is the better the potential profit from the option. Owners of those $90 call options know that, and ask for a somewhat higher premium - reflective of that possible better opportunity.
Usually, a raise in rates of interest does mean a raise in call prices and a drop off in put options prices. And contrariwise. This assumption is not always true though.
Nonetheless, this is only an insignificant component at best when compared to a time premium of an option.Once more, when a trader buys an option, no one of above stated three factors can be managed. But, being aware of what effect they can have to a price of an option will as a minimum help a trader appraise a progress of the option trade or lack thereof.