Determinants of Option Price (1)
The most important influence is the stock price
If the stock price is far above or far below the striking price, the other factors have little influence.
Before we proceed further we need to understand that option price = intrinsic value + extrinsic value.
We shall focus only on intrinsic value today.
Simply put, intrinsic value is the difference between your strike price and the underlying stock price.
For example, Facebook (FB) is priced at $250 today. If my call option has a strike price of $240 (i.e. I can buy FB at $240 instead of $250), I get a profit of $10.
This $10 is also known as intrinsic value.
When the option position is a profitable one for the buyer, it is also referred to as in-the-money (IMT), a common jargon used.
Alright! Back to how stock price influences option price.
The best way to observe this is to look at the option price on the expiration date.
FB Mar 140 call option gives the buyer the right to buy FB shares at $140 in March. Hence, come March, if FB trades above $140, it becomes profitable.
Here we can see clearly see how FB stock price drove the call option price.
At expiration, the price of the option is directly equivalent to the difference between the strike price and the underlying stock price.
This can be easily represented by the chart below!
When a call option still has time till expiration, there’ll be extrinsic value in the pricing. Which we will cover in our future posts.
Till next time!