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How are option prices computed?

How are option prices computed?

Option prices are decided by the buyers and sellers in the marketplace, but are tied closely to the amount of risk inherent in the agreed upon expiration date and strike price.

Option prices change as the market factors in the relevant information. The main factor is the strike price. The closer an option’s strike price is to the actual market price of a security, the higher it’s price will be.

Once it’s in-the-money, it has inherent value that makes it essentially the same price as the market security that underlies it. The expiration date of the contract is also a factor because if the expiration date is closing in, and the strike price is not quite close enough to the market price of the underlying asset, there is little chance that the option will be useful.

This is called time decay. Another important factor is the volatility of the underlying stock. The higher the volatility, the greater the chance that the price will cross over the breakeven point for the options position.

The expected future volatility of an underlying stock is priced into an options contract by the market, and analysis can control for the other factors that affect options prices (money-ness and time decay) to find the amount of the price movement that is due to what’s called implied volatility. There are very specific mathematical ways or arriving at options prices.

For European style options and American style calls when the underlying does not pay dividends, the Black-Scholes formula can be used. For American Style calls on dividend-paying stocks and American style puts, other formulas that have been built on the shoulders of the Black-Scholes formula can be used. Binomial trees can also be used for all option types.

Keywords: volatility, portfolio management, implied volatility, strike price, options, time decay, binomial trees, Black-Scholes,
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