Determining Option Value

Determining option value can be done by evaluation of basic aspects of the option. The current market price of the underlying security, the strike price of the option, time to expiration of the option, and the cost or benefit of holding the option position all are standard factors in determining option value. The remaining basic factor in determining option value is a prediction of the future value of the underlying security.

In determining option value of a call option on 100 shares of stock we know the strike price, which is the price of the security when the option is written and the price of the underlying stock if the option is exercised. We also know the current market price of the stock. If the security has gone up in price, part of the option’s value will be the current market price minus the strike price for the block of stocks.

If you borrowed money to buy the option or simply took money from your bank account there is a cost to holding the position. The cost of holding the option position should be subtracted from any option value gained from a stock price increase. This factor especially applies to holding on to an option instead of selling it. Another factor is if the stock pays dividends. The value of the option will include the value of the dividend on the block of stocks up until when the dividend is paid. Then the option value goes down by the value of the dividend.

Determining option value also includes the time remaining to expiration of the options contract. In the example of purchasing a call option you may be “in the money” in that the current stock price is above the strike price. If the underlying stock is slowly increasing in value it may be that letting the option contract ride a little longer will allow you to make more money when you exercise the option. This factor in determining option value leads to the next factor, predicting the future of the underlying stock.

Determining option value really hinges on this factor. Everything else can be calculated with addition and subtraction. Predicting the future relies on the probabilities that the stock’s price will either go up or down. This factor is what makes the purchase of call options potentially lucrative. One pays a small amount, a premium, to purchase the right to buy stock at a set price, the strike price, no matter how high the stock price may go.

If you believe that a stock will go up you can buy the stock, wait for the rise in stock value, and sell, pocketing your profit, minus commissions. If you choose to purchase an option on the same stock you risk losing your premium but can exercise the option to buy at the strike price while you simultaneously sell at the spot price or market price.

Thus, of the various factors, determining option value relies, potentially, most heavily on predicting how much the underlying stock will be up until expiration.