The value of an option is determined using option valuation models. These models can figure out the current value using certain inputs and can also calculate the hypothetical value based on changes of the different inputs into the model. The most popular model is based on a formula called the Black-Scholes Formula.
The Black-Scholes formula
The Black-Scholes model was the first formula that was able to accurately determine the value of an option. The formula was created by Fischer Black and Myron Scholes and was one of the biggest breakthroughs in the history of theoretical finance. Their ground-breaking work led to a Nobel Prize in Economics in 1997 for Myron Scholes and Robert Merton, who was the first to publish a paper about Black-Scholes (Fischer Black was ineligible for the prize because of his death in 1995).
Over the past 20 years or so there have been theoretical advancements made to options valuation due to new insights about the impact of volatility and other factors. But for a beginner it is fine to use the Black-Scholes formula as your valuation tool.
Options Price Factors
Although the math behind the formula is very complex, it is not hard to conceptually understand what determines the price of the option. The variables that are put into the Black-Scholes formula are as follows:
- The market price of the underlying security. A rise in price will increase call price and decrease put prices and vice versa.
- Strike price. The price at which the option can be exercised. Also, the price at which the option begins to accumulate intrinsic value.
- Time left until expiration. The more time until expiration the more the option will be worth. Time value decay accelerates as expiration gets closer.
- Implied Volatility. This is the estimation of the volatility of the underlying security during the life of the option. Everything else being equal a higher level of volatility will mean a higher option price. This is because the higher the volatility the higher the probability a security will hit a certain price.
- Interest rate. The risk-free interest rate until the option expires. A rise in interest rates results in higher call option prices and lower put options prices and vice versa.
- Dividends. The higher the dividends are the lower the call premiums and higher the put premiums will be.
As a beginning trader don't waste your time with the math involved with options. Get to know the variables and how they affect an options price. If you have a PhD in math and want to get deep into the calculus of the valuation formulas then go for it. But if you do this keep in mind two things. First, there are very little arbitrage opportunities - especially for retail traders - so don't get hooked on the idea that you'll be able to squeeze out easy profits by finding mispriced options.
The second thing to remember is that getting tied up in theory has its own downside. By worrying about the technical minutia of how markets work you miss out on learning the critical success factors in trading like learning about market psychology. This is particularly applicable to anyone who has a PhD or someone coming from the hard sciences like physics. These people tend to view the market as a mathematical formula that has a static solution instead of the dynamic animal that it is.