Valuing Options

Options are often priced by factoring in the underlyer’s current price, intrinsic value of the option, time value, volatility, and interest rates.

Intrinsic value is the value any given option would have if it were to be exercised today.

Intrinsic Value (Call option): The difference between the market value of the underlying asset and the Strike price of the call option. The intrinsic value is zero if the underlyer’s price is less than the Strike price. Call Option Intrinsic Value = Underlying Asset’s Current Price minus Call Strike Price.

Intrinsic Value (Put option): The difference between the market value of the underlying asset and the Strike price of the put option. The intrinsic value is zero if the underlyer’s price is greater than the strike price. Put Option Intrinsic Value = Put Strike Price minus Underlying Asset’s Current Price.

Time Value: Time value of an option accounts for how much time an option has until it expires and the volatility in the underlying asset’s price. The more time an option has until it expires, the greater the probability it ends up in-the-money (profitable). The time component of an option decays exponentially.

Volatility: Underlying assets with high volatility have a higher probability for the option to be in-the-money at expiry. Hence, time value is typically higher to compensate for the increased change that the underlying asset’s price could move beyond the strike price and expire in-the-money.

Implied Volatility: Implied volatility represents the expected volatility of an underlying asset over the life of the option, and approximates the future value of the option (forward looking) which may reflect market factors (e.g. supply and demand of the underlying options, liquidity of the contract, etc).

Realized Volatility: Often referred to as historical volatility which measures past market changes (backwards looking) and is a statistical measure of the dispersion of returns for the asset over a period of time. It is often calculated by using the standard deviation of returns.

Impact of Volatility on Options: A higher volatility means that large price movements are more probable and hence increases the probability that, if exercised, the option will have a bigger payout. Ceteris paribus, higher volatility increases the value of the option.