The Value of an Option

Options have value for the same reason that insurance policies have value.
In its simplest form, if there were a 1% chance that a house might burn down in a given year, then insurance companies would charge an annual insurance premium of 1% of the value of the house, plus a mark-up to cover expenses and a profit margin.
Options on stocks and ETFs are basically the same as a typical insurance policy on a home. After all, there is some percentage of chance that a stock will rise or fall dramatically.

Consider the components that go into an insurance policy: asset value, deductible, time, interest rates, risk and premium. The components of an option’s value or price of an option correspond directly to these same factors.
Stock price corresponds to asset value. All things being equal, the more expensive an asset, the more expensive it is to insure. Similarly, the higher a stock’s price, the higher the price of an option on that stock.
An option’s strike price corresponds to the deductible of an insurance policy. Policies with small or no deductibles are more expensive than policies with larger deductibles. An out-of-the-money strike is like an insurance policy with a deductible. The first portion of loss is created by the insurance party, in our case, the owner of the stock). When a loss exceeds the deductible, the insurance policy kicks in. In the case of options, the “protection” is the options intrinsic value, which increases as the stock price moves beyond the option’s strike price.
Time has a direct impact on option prices just as it has on insurance policies. The longer the period to expiration, the higher the option value.
Interest rates are a factor in option prices because of the time value of money. If call options, for example, could be purchased below the value of the interest on the cost of the underlying stock, it would be advantageous for the stock investors to buy Treasury bills (T-bills) and calls rather than the underlying stock. Consequently, the options market constantly adjusts option prices as interest rates change.
Dividends also affect option prices, but the effect is somewhat difficult for option newbies to grasp. Dividends are, in essence, like an interest payment paid by the stock. Owning a stock which pays a dividend is more attractive than owning a stock which does not, all things being equal. Therefore, call options on dividend-paying stocks are less valuable than calls on non-dividend-paying stocks, again, all things being equal. As dividends rise, call values fall and put values rise.
Volatility in options corresponds to risk in insurance. In the normal course of trading, stock prices fluctuate. The larger the price fluctuates, the riskier the stock, and therefore, the more expensive the options on that particular stock or ETF. Volatility is a subject that takes time to understand. Newbies to options should be patient, and they should remind themselves not to be intimidated by more experienced options traders who understand it. By asking questions, however, anyone can grasp the concept of volatility as well as any other options-related concept . . . which is why I encourage all of you to ask, ask, ask . . .
Please do not hesitate to email me at andy.crowder@wyattresearch with any and all questions you have on options. I look forward to hearing from you. If  you would like even more ideas regarding options trading, don’t forget to sign up for my free weekly options report, The Strike Price.

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