The Anatomy of a Stock Option Price

Before any trader uses stock options they must understand how options are priced. Options are not assets they are perishable bets on the price of a stock during the time frame of the option. Stock option contracts have different strike prices for different time frames. Inside their prices are imbedded the cost of time, volatility risk, and the probabilities of the option expiring in the money.

Option traders must also consider the dangers of liquidity risk and only trade options with tight bid/ask spreads with plenty of contracts traded. Also know that as your option gets farther and farther away from being at the money liquidity dries up. When trading with options it is crucial to only risk the same amount of capital you would trading the stock. If you trade 100 shares of Apple the odds are that you should only trade 1 Apple contact controlling a hundred shares. Options can be great tools for risk management but if you trade them not understanding how their prices work they can also be dangerous and lead to large losses.

Here is the brief anatomy of the option pricing model based on the “Greeks”

Delta: The ratio comparing the rate of  change captured in the option compared to the price change of the stock corresponding to that option. If your option contract moves up $1 for every $2 the stock moves the option has a .50 delta. You are capturing 50% of the underlying move. The odds that your option will expire in the money in the time frame before its expiration  is the driver of the velocity of delta capture.

Theta: Is the extrinsic cost of the time you will be controlling a stock’s movement through an option purchase. It is the measure of the rate of decline in the value of an option due to the passage of time. If everything is held constant, then the option will lose value as time moves closer to expiration of the option leaving the option worth only intrinsic value after expiration.

Vega: The measurement of an option’s sensitivity to changes in the volatility of the underlying asset buy adding and subtracting premium to adjust for implied risks in movement. Volatility measures the amount and speed at which price moves up and down, and is often based on changes in recent prices in a stock. Vega changes when there are large price movements (increased volatility) in the stock, and falls as the option approaches expiration.

Rho: The rate at which the price of an option changes relative to a change in the risk-free rate of interest. Rho measures the sensitivity of an option or options portfolio to a change in interest rate. This is the least important Greek and rarely comes into serious play unless there is a huge change in interest rates.