Intro
The value of an option contract depends on many things but the most important factors are:
- implied volatility - stocks that historically have high volatility (i.e.biotech stocks) will have more expensive options compared to lower volatility stocks like utilities. Broad market index ETFs should have even lower volatility thanks to being diversified.
- strike price - higher strike prices have higher prices on calls and lower prices on puts. It's more expensive to buy a $50 call than a $45 call option for the same stock on the same expiry.
- expiry - longer-dated options are priced higher than shorter-dated ones. In June, a $20 call option should cost more if you choose a December expiry vs a September expiry.
When you're buying or selling an option, most often your counterparty will be a market maker.
Market makers will employ complex mathematical models to arrive at the actual pricing of options. As the market price of the underlying asset moves, so do option prices.
However, a $1 move in the underlying asset will trigger a different price move in a $100 call strike option compared to a $50 call option, if the stock is priced at $52 and moves to $53. The $50 call that is already in the money will move almost in tandem with the actual stock price, while the deeply out of the money $100 call option may change a few cents only. This sensitivity is described by the term Delta. Other Greeks are also used to describe the characteristics of options; for example, Theta shows the effect of time decay, which denotes the rate at which the value of an option contract declines due to the passage of time.
The pricing of options
Bid-ask spread for options
Once you've selected the desired expiry and strike price for the underlying asset in the option chain, you're ready to place your trade.
The bid price is the price at which you can sell the option
The ask price is the price the you'd need to pay to own the option
The difference between the two prices is called the spread. Spreads can be very wide for small cap stocks or other instruments that are not traded frequently.
Also, you'll find very wide spreads on strike prices that are far away from the current price.
It usually makes sense to place a limit order and try to bargain for a better price. For example, if the bid is $1.50 and the ask is $2.00 and you try to buy this option, you could first enter a limit order for $1.60 and move your offer higher to $1.70 or $1.80 if it doesn't get filled.
The pricing of options
Where to look for more?
Hope you liked this quick rundown about options. If you'd like to dig deeper, navigate to one of the articles below:
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