Where Do Option Prices Come From?

Where do option prices come from? The price to purchase an option is referred to as the option’s premium. The premium depends on the current price of the stock, the option’s strike price, the volatility of the stock’s returns, interest rates and how long the option has until expiration.

Finding the premium starts with the option’s intrinsic value. The intrinsic value is simply the difference between the current price of the stock and the strike price in the options contract.

Photo by Katrina.Tuliao, courtesy of flickr

For call options, the intrinsic value equals the current price minus the strike price.

For put options, the intrinsic value equals the strike price minus the current price.

Above and beyond the option’s intrinsic value, it’s premium will depend on risk, interest rates and time.

Increasing risk increases the value of call and put options. Risk is measured by the historical standard deviation of a stock’s returns. So, stocks with a history of more volatile returns will have more expensive options.

Increasing interest rates has a different effect on call and put options. The interest rate used in option pricing models is the risk-free rate of return. It represents the time value of money. Since options will be exercised at some point in the future, the cash flows must be discounted. The higher the rate, the greater the discount, so higher rates make call options more valuable and put options less valuable. 

Increasing time increases the value of both call and put options. The longer the option has to expire, the more opportunity there is for prices to fluctuate. All else held constant, a lengthier option will have a higher premium.

So, there you have it. Option premiums are based on the current price, the strike price, risk, interest rates and time. Tomorrow, I’ll post on “Wall Street Vixens” to discuss indicators of risk in the options market.

While I did not provide the formulas, the option pricing model I described is the Black-Scholes Option Pricing Model. Here is an option pricing calculator on blobek.com.