How Stock Options are Priced

If you are interested in trading options the first place you must start is having a basic understanding of what determines there price. Understanding what determines their value and how they move in step with the underlying stock is the first crucial step before you start trading them. Not understanding what can cause sudden drops and spikes in an options price can leave a new option trader with some very big surprises. Most of the time those surprises are not good. I am going to try to keep these explanations as simple and easy to understand as possible and try to avoid all the charts and graphs that make readers’ eyes glaze over. My goal here is to focus on explanations only on a need to know basis and stick to only what matters in your quest to make money trading options and avoid any big surprises.

Option contracts are priced based on the Black-Scholes pricing model to determine their value at any given time. Stock options are contracts, they are not assets like stocks or bonds. They are more of a bet on the price of a stock at a certain point in time and not an investment in something with intrinsic value like a stock of a company with earnings or a commodity futures contract of something tangible. The interesting thing is what determines their values and price. To trade options you have to understand the basics of Greeks in determining how their value is calculated and whether are not you will profit from them if you get the move in price that you expect before expiration. Options are priced based on the value of the time left before expiration and the current assets volatility or expectation of volatility due to an upcoming event like earnings or an important report. Interest rates use to be a consideration in pricing before recent times when rates have gone flat basically. Options will go up as the probabilities of them expiring in the money increase and will go down as the probabilities of them expiring in the money decreases. As options get closer to being in-the-money they capture more of their underlying assets move, as they get farther away from being in-the-money they capture less of their underlying assets move.

The basics of the ‘Greeks’:

Theta measures the rate of decline in the price of an option due to time passing.  Theta is also called time decay in the option world as the value of an option declines day after day. Theta measures the time value that you pay to hold the contract, in essence you are paying to rent the shares for a set period of time. This is in addition to any intrinsic value of the option if it is in-the-money. A percentage of your time value disappears out of the price of the option each day that you hold the contract after it is purchased. Options are wasting assets, their life span is set only until the expiration date and at that time the option owner has the right to call the stock to be bought at the strike price for a call option or to put a stock on someone for the strike price of a put option. The theta value is like the countdown clock where time is money on the path to the expiration giving the option buyer the right to execute the contract.

At expiration the time value is zero and you are left with the difference in the intrinsic value that the option entitles you to buy or sell a stock for versus the open market price. The velocity of the time value decline starts out slower when the option is months away from expiration and accelerates in the final month to expiration and is very fast in the last week before expiration. Far out-of-the-money options and far-out-of-the-month options are made up almost entirely of time value along with volatility priced in if any events will happen before expiration because options so far away in time and price do not have any other type of value. On the last day of an options expiration the option will have almost zero time value as only one day is left. Just remember that when you enter a stock option trade you are on the clock. The stock has to move close enough to the price of your stock to pay for the time you spend holding it. For a longer term trade you have to overcome the cost of time to be profitable in your option. Stocks have no time expense, you are not renting a stock when you own it you are taking on the full risk of the asset. With options you have to pay rent to own the rights to buy or sale a stock at a certain price over a time frame. The theta value is what you are paying someone for the time they spend exposed to the risk of you calling or putting an asset on them at expiration.

Delta measures the amount that an option is exposed to the moves in the price of the underlying asset it is written on a scale from 1.00 to -1.00. Deep-in-the-money options eventually move dollar for dollar with the underlying stock. If a stock is $100 and you own a $96 deep-in-the-money strike price weekly option then it is likely the option price will move close to dollar for dollar with the stock price. If the stock goes up $1 then your option contract will go up close to $1 because the odds are almost 100% that your option will expire in-the-money in one week, so your delta will be close to 1.00. Options that are right at-the-money will generally only move .50 cents for every dollar move in the underlying, this is due to the probabilities being 50% that the options will end up expiring in the money. This is because it is about 50/50 odds that something will move either up or down. If you have a $100 at-the-money-option and the stock is at $100 then moves to $102 the odds are that your option will only move $1 or half as much as the stock because the delta was .50 for your at-the-money-option. Delta increases as a stock goes farther in the money due to better odds of expiring in-the-money and decreases as it goes farther away from the money due to decreasing probabilities of it expiring with intrinsic value. Understanding the odds based on your option delta can be very enlightening. A 1.00 delta projects a current probability of a 100% that your option will expire in-the-money, a .50 delta projects about a 50% chance that your current option will expire in-the-money, and a .10 delta gives a current probability of only 10% that your current option will expire in-the-money.

Note that calls and puts have opposite deltas – call options are positive and put options are negative. A put option moves inversely to a call option.

Whenever you are long a call option, your delta will always be a positive number between 0 and 1. When the underlying stock or futures contract increases in price, the value of your call option will also increase by the call options delta value. Conversely, when the underlying market price decreases the value of your call option will also decrease by the amount of the delta.

Put options have negative deltas, which will range between -1 and 0. When the underlying market price increases the value of your put option will decreases by the amount of the delta value. Conversely, when the price of the underlying asset decreases, the value of the put option will increase by the amount of the delta value.

Delta also correlates closely with how much intrinsic value your option captures dollar for dollar with the underlying stock:

1.00 delta = $1 option gain in a call option for $1 stock movement up.

.50 delta = $0.50 option gain for a call option for $1 stock movement up.

The same is true for a move against your option.

1.00 delta = $1 option loss in a call option for $1 stock movement down.

.50 delta = $0.50 option loss in a call option for $1 stock movement down.

The Delta of your option is the percentage of the move in the underlying stock that your option will capture currently based on the odds of your option expiring in-the-money.

Vega measures an option’s sensitivity when there are changes in volatility of the underlying asset. Vega value shows the amount that an option contract’s price can change as a result to a 1% change in the volatility of the underlying asset the option is written on. The volatility of an asset is measured by the magnitude and speed that price moves up or down, and can be based on any changes in the recent price range or historical prices in a stock or commodity future. Vega will change as their are large price changes in a stock or commodity an option is written on. Vega value in the price of an option will decrease as the option gets close to it’s expiration date. Vega is the pricing of options to account for the risk that a seller is taking on based on the current and estimated volatility of the underlying stock. Options increase in value during times of greater volatility and decrease in times of less volatility.

If you purchase a stock that is on a company that will announce its earnings before the options expire the expected volatility of that event will be priced in to the option. An at-the-money option will give you an idea of the expected move of a stock. If a stock is at $100 and an at-the-money $100 strike call option is normally $3 one week until expiration but earnings are before expiration and the $100 strike is $13 instead of the normal $3 then the odds are that the $3 is the normal theta value and the extra $10 is the Vega value pricing in a $10 move after earnings. One thing that trips up new option traders is that that $10 value will be almost completely gone when the option opens for trading the following morning after earnings are announced and digested. the stock could open at $110 and your option still only be worth $13 as your Vega value has been replaced by intrinsic value and you could still have $3 in theta value. To trade options through earnings you have to overcome the price of the volatility that will be gone after the even with intrinsic value of the option going in-the-money to be profitable. Vega can also be priced in to options before major events like Fed minutes, A congressional bill, a crop report, or a big jobs report. Always be aware that options are pricing in moves in time and volatility to compensate the option sellers for their risk taking. Option pricing is very efficient for the known volatility of events. It is the following of trends, systems, reactive technical analysis, and risk/reward ratios that can provide an edge. 

Gamma describes how much the options delta changes as the price of the underlying stock changes. The option’s gamma value is a measurement of the speed of change of the option’s delta. The gamma value of an option contract is a percentage and shows the change in the delta  when there is a one point move in the price of the underlying stock. The options Gamma value measures the magnitude and the direction of a change in the option’s delta. Deltas expand and become higher as price moves in favor of your option’s strike price. Options capture more intrinsic value as price moves in-the-money of your options strike price. Deltas become smaller as price moves against your option positions strike price needed for the option to go in the money. As price moves away from your strike price needed for profitability the movement become smaller and smaller on the option as the delta declines. Gamma is the measurement of this rate of change of the Delta.

A Gamma scalper of options is simply trying yo buy an out-of-the-money option with nothing but time value and a very low delta and profit by the option delta expanding and increasing in value. An out-of- the-money option with very little premium value can go up in price as the odds of it going in-the-money increases and the delta capture rapidly expands. A Gamma scalper will buy an option with only Theta value and profit from the Gamma of a rapidly increasing Delta. These types of trades usually have lower win percentages but can be profitable with wins that are 100% or more. The key with these types of trades which many new option traders love is to trade them with a small amount of trading capital. 0.25% or 0.5%  of total trading capital at risk is a good position size for these types of high reward but low probability of success trades. Gamma scalper does not need his option to go in-the-money to be profitable, he only needs the odds of it going into the money to increase so he can sell it for a profit.

Rho measures the sensitivity of a stock option’s price to a change in interest rates. This is almost never considered due to the stability of interest rates the vast majority of the time over the last decade.

Understanding what your option will be potentially be worth even if the price of the stock goes in your favor is crucial. You have to consider the time value above the strike price will all by gone by expiration. The expected magnitude of volatility of known events are priced in to the option price so the move has to be greater than expected to overcome the Vega value that will disappear after the event. Gamma will dramatically increase the value of an out-of-the-money option as it moves closer to the money on a percentage of price basis. You do not want to be right about the price move and right about the time frame but still not make any money because you did not consider the time decay in price or volatility being priced out after an event. Know your Greeks.