No statement in this web site is to be construed as a recommendation  by Trading Options For Income to purchase or sell a security, or to provide investment advice. Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options . Copies of this document may be obtained from your broker, from any exchange on which options are traded or by contacting The Options Clearing Corporation, One North Wacker Dr., Suite 500 Chicago, IL 60606 (1-800-678-4667).








                                                                                                                                                                     

                                                                                                                                                                 


When the underlying security's price is higher than the strike price a call option is said to be "in-the-money." If the underlying security's price is less than the strike price, a put option is "in-the-money." Only in-the-money options have intrinsic value, representing the difference between the current price of the underlying security and the option's exercise price, or strike price. Prior to expiration, any premium in excess of intrinsic value is called time value. Time value is also known as the amount an investor is willing to pay for an option above its intrinsic value, in the hope that at some time prior to expiration its value will increase because of a favorable change in the price of the underlying security. The longer the amount of time for market conditions to work to an investor's benefit, the greater the time value. There are several other factors that determine options pricing. Some factors are much more important than others and while some are readily known as fact (such as time until expiration), some are theoretical and therefore subject to interpretation (implied volatility).

The most basic and easily understood factor is change in the underlying security price which can increase or decrease the value of an option. These price changes have opposite effects on calls and puts. For instance, as the value of the underlying security rises, a call will generally increase and the value of a put will generally decrease in price. A decrease in the underlying security's value will generally have the opposite effect. The strike price determines whether or not an option has any intrinsic value. An option's premium (intrinsic value plus time value) generally increases as the option becomes further in the money, and decreases as the option becomes more deeply out of the money. Another, albeit traditionally less important factor, is the effect of an underlying security's dividends and the current risk-free interest rate.

This affect has a small but measurable effect on option premiums. This reflects the interest that might be paid for margin or received from alternative investments (such as a Treasury bill), and the dividends that would be received by owning the shares outright. The interest rate and dividend affect can have a much more significant impact on options pricing in times of high interest rates  or when dividends, as expressed as a percentage of an stock’s price, is much higher than historical levels. A good example of this at the current moment is General Electric (GE). The stock price of G.E . has dropped significantly over the past few months and stands at about $13.00 @ today’s trading. GE’s dividend, expressed as a percentage of the stock price, is a whopping 12%! Obviously that will have a greater impact on the pricing of the option as opposed to when GE was trading at $50.00!

Time until expiration, as discussed in our previous post, affects the time value component of an option's premium. Generally, as expiration approaches, the levels of an option's time value, for both, puts and calls, decreases. This effect is most noticeable with at-the-money options.

Implied Volatility is the most subjective and the most difficult factor to quantify, but it can have a significant impact on the value of an option's premium. Volatility is simply a measure of risk (uncertainty), or variability of price of an option's underlying security. Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike.

Another factor that impacts the real value of an option is liquidity. If a contract is illiquid, generally the bid and ask spreads are wider. Lack of liquidity might make it difficult if not outright impossible to trade the contract. As you can see, options pricing is much more complex than plugging a few numbers into a formula. That will only account for the theoretical value of a contract and not the actual market value of an options contract.


                                                                                             Madeira Investments LLC
                                                                                 D/B/A Trading Options For Income
                                                                                          8770 Sunset Drive # 201
                                                                                        Miami, Florida 33173-3512
                                                                                   www.tradingoptionsforincome.com
                                                                                               Tel: 305-432-5066
                                                                                              Fax: 305-279-0532
                                                                                   Copyright © 2008 Trading Options For Income. All rights reserved