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Fundamentals of Option Valuation - Video & Lesson Transcript

This document discusses the fundamentals of option valuation. It explains that options are financial derivatives that derive their value from an underlying asset, usually a stock. There are four key components that influence the price of an option: (1) the current spot price of the underlying stock, (2) the strike price of the option, (3) the time until the option expires, and (4) the volatility of the underlying stock. Together these factors are considered in pricing options, with more time, a greater difference between the spot and strike price, and higher volatility resulting in a higher option price.

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12 views

Fundamentals of Option Valuation - Video & Lesson Transcript

This document discusses the fundamentals of option valuation. It explains that options are financial derivatives that derive their value from an underlying asset, usually a stock. There are four key components that influence the price of an option: (1) the current spot price of the underlying stock, (2) the strike price of the option, (3) the time until the option expires, and (4) the volatility of the underlying stock. Together these factors are considered in pricing options, with more time, a greater difference between the spot and strike price, and higher volatility resulting in a higher option price.

Uploaded by

veronica
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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11/7/2019 Fundamentals of Option Valuation - Video & Lesson Transcript | Study.

com

Fundamentals of Option Valuation

Lesson Transcript

Option contracts are derivative nancial instruments that obtain their value from an underlying asset - usually a
stock. In this lesson, we'll discuss the components that are involved in determining the exact price of an options
contract.

Derivatives
One share of XYZ stock may cost $45. Depending on a couple factors, the cost of an options
contract for XYZ may be anywhere from $0.05 to $75, or higher. To understand why, we need to
talk about the fundamental basics of pricing options. To do that, we need to rst understand
nancial instruments called derivatives.

Derivatives are nancial instruments, like options, that get their value from a di erent asset,
called the underlying asset. You may have heard 'oil futures' discussed around the o ce or on the
news. Oil futures are another kind of derivative that gets their value from a barrel of oil. If you buy
an oil futures contract, you aren't buying a barrel of oil, but you are buying a contract to buy oil at a
later date. So, the oil future is a derivative that gets its values from oil.

Options are derivatives, and for the examples we'll use in this lesson to highlight how options are
valued, we'll talk about options with an underlying asset of stock shares. For simplicity's sake, we'll
focus on call options, those options that give you the opportunity to buy stock at a future date for
a predetermined price.

Options
As mentioned earlier, option contracts (often just called options) are contracts to purchase
something at a future date, also called the expiration date, and at a future price agreed upon when
the contract is written, or the strike price. When you buy an option, you aren't going through the
process of actually writing a contract (all that has already been done), and after it has been done, it
trades on a market just like a stock.

You might log into your brokerage account and search for some XYZ options. You'll have an option
to look at calls or puts, and remember, for this lesson, we are focusing on calls. Everything we say
also applies to puts, it's just with puts you are buying the option to sell the stock, not buy it like you

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are when you buy a call. One more easy de nition so we can have this conversation: The spot
price of any nancial instrument is the price at which it is currently trading. So, if you want to know
the spot price of your favorite stock, just look it up on a nance website and that's the spot price.

For fun, let's think about an option for XYZ that has an expiration of May 2016 and a strike price of
$50. Those would probably cost you about $3 a share, or $300 for a contract. So, what needs to
happen to XYZ for you to make money? It's currently at $45, so if you want to make money by
buying it at $50, you need it to climb to at least $53 per share, right? After all, don't forget the $3
per share you paid for the option you need to make up. Anything above that at any point between
now and May 2016, and you'll make money.

Option Pricing
With that background behind us, let's talk about the four components of options pricing. It's
important to note that while we are going to talk about this at a basic level, the practice of pricing
options is far from simple. Entire books and algorithms are written to price options and then look
for options that are incorrectly priced.

Now, why did that option for XYZ cost you $3 per share if the strike price was $50 but the spot price
is $45? Why would you pay $3 for the opportunity to pay $50 for shares in May 2016 that cost $45
now? Probably because you think the price in May 2016 will be higher than $50 (signi cantly
higher) and you don't want to tie all your capital up in actually owning the stock.

But the seller of the option knows that as well. The entire market knows that seven months is a
long time, so before anyone agrees to originally be obligated to sell shares at $50, they want some
compensation for their risk; hence the $3. They get to keep the $3 no matter what, so if the price of
XYZ never goes above $50, they win. If it does, however, they owe someone some cheap shares.

Along with time, there are another two factors that in uence the price of an option, although they
work together to determine the in uence on the option price. One is the spot price, or the current
price of the underlying stock. The second is the strike price, or the price at which you can buy or
sell the stock, based on your contract. The further away the spot price and the strike price, the
higher the in uence on the stock price. A big distance may make your option worth more, like if
your stock is in the money, meaning that your strike price is lower than the spot price for a call.
For a put, you are in the money when the spot price is lower than the strike price.

Finally, there's one last component that plays an important role in the price of an option, and that's
the volatility of the stock. Remember, stocks with high volatility go up and down a lot. If you have
a volatile stock, seven months, and it only needs to move $5, it probably will. If you are probably
going to make money, it's going to cost you a little more to make it. Remember, any advantage you
want in the stock market is going to cost you money.

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Basically, imagine an equation that simply says, time + volatility + (strike price - spot price) = options
price. That isn't an actual mathematical formula to use, since there aren't any metrics to put in
place of the words, but the words describe what components are considered when pricing an
options contract.

Lesson Summary
Option contracts are complicated nancial derivatives, but once understood, can be helpful and
lucrative investment opportunities. Remember, the following factors impact options pricing:

Spot price of underlying stock

Strike price of options contract

Time until expiration

Volatility of underlying stock

While this lesson scratched the surface of what is considered when pricing options, additional
research and experience will help you understand the pricing process in more detail. Once you
understand that, you can look for opportunities to take advantage of prices that might be a little
low, or high, on stocks that you've analyzed for future movements.

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