Understanding Stock Option Valuation.. Module 2

The 6 factors that control the price and profit potential of options...

Stock Option Valuation (options pricing) is a complex topic and probably one of the toughest concepts you will encounter as you learn about options trading.

Stock options are very different from shares of stock.

They have very specific and unique characteristics.

It is these characteristics that are going to determine if we are able to make a profit from the purchase of the option.

If you just blindly start trading stock options without having at least a basic understanding of stock option valuation and why options behave the way they do, then you're going to be in trouble and possibly lose a great deal of money.

It's like being a person who doesn't understand that it's a bad idea to go swimming in shark infested waters when you have a bleeding leg.

Factors That Affect Stock Option Valuation...

There are several components to stock option valuation (options pricing) that you should be aware of.

It's not enough to merely know that you're going to buy an option contract and sell it later down the road.

The reason that stock option valuation is such an important concept is because option price does not always move in conjunction with the price of the underlying stock.

There are other factors involved.

The following are six factors that determine what the price/cost of the option will be:

• The current market price of the stock
• The strike price of the option (particularly in relation to the current market price of the stock)
• Remaining life of the option (time left until expiration)
• Volatility
• Interest rates
• Stock Dividends

Interest rates and stock dividends are beyond the scope of this lesson. We will only be focusing on the first four.

**Side Note** If you hear someone talk about an options premium, or ask price they are talking about the cost to buy that option. So premium, and ask price are terms that mean how much you will pay to buy an option.

"The current market price of the stock:" When the stock price "increases" a Call options premium will "increase", but a Put options premium will "decrease".

When the stock price "decreases" a Call options premium will "decrease", and the Put options premium will "increase".

One easy way to remember it is that with "Call options" their price follows the direct movement of the stock price.

If the stock moves up so will the Call options premium. If the stock price moves down the Call option will begin to lose value.

Put options are the exact opposite.

Lesson Review

Buy Calls when you think the stock is going up and buy Puts when you think the stock is going down.

• If you buy a Call and the stock price goes down you will begin to lose money.
• If you buy a Put and the stock goes up you will begin to lose money.

An options cost or market value is often called the premium.

All six of the above factors play an important role in determining an option's price.

However, the only two factors that an investor has any control over are time to expiration and the strike price.

These are the two factors that we will discuss in the next few modules.