So what determines an option’s value? In general, the option’s price is determined by the perceived probability of it expiring in-the-money. Of course, the basic fundamental forces of supply and demand still hold. Ultimately, the contract is worth whatever someone will pay for it.
There are three major factors that determine the option’s price (premium): the underlying market, volatility and time remaining to expiration.
- Underlying: The main factor determining the option’s price is the price of the underlying futures contract. The price of the underlying determines if the option is in-the-money or out-of-the-money. For example, if the price of the underlying market rallies, investors likely will pay more for the right to buy call options.
- Time: The more time there is until expiration, the greater the chance that the option could finish in-the-money. Therefore, the price of the option will be higher. The passage of time works against the option buyer because out-of-the-money options decrease in value at an accelerating rate as the expiration date approaches. This is commonly known as time-decay.
- Volatility: The price of an option is also determined by volatility. As market participants anticipate large price swings, the chances of an option finishing in-the-money theoretically goes up, as will its value. An option in a volatile market is worth more than one in a calm market. Buyers of options are said to be long volatility, while sellers are short volatility.
Advanced Terminology: The Greeks
The Greeks (e.g. delta, theta, vega) are basically tools used by option traders to manage risk. Each Greek letter corresponds to a unique measurement, the most common being delta.
The amount the value of the option changes in relation to the movement of the underlying is known as its delta. The delta is a number between -100 and 100. The deltas of calls range from zero to 100, with out-of-the-money calls closer to zero and in-the-money calls closer to 100. The deltas of puts range from zero to -100, with out-of-the-money puts closer to zero and in-the-money puts closer to -100. At-the-money calls and puts have deltas near 50 and -50, respectively.
Theta measures the rate at which an option loses its value as time nears expiration. Theta is known as the time decay factor and is usually expressed as a negative number, representing the loss of value as time passes. For example, if the theta is -.20, the option will lose $0.20 in value per day for each $1 in underlying price movement. If you are short options, a positive theta and time decay can work for you. If you are expecting a stable market, a short options position will make time decay work in your favor.
The vega, although not officially a Greek letter, and sometimes known as kappa measures the sensitivity to volatility. The option’s vega shows how much of a change in price to expect for a one-percentage point increase in implied volatility. Long option positions always have a positive vega. An option’s vega decreases with the passage of time.
As the price of the underlying changes, so does the delta. The gamma measures the change in the delta as the price of the underlying changes. Gamma is used more commonly among professionals that need to manage the risk of large positions.
Rho measures the effect of interest rates. Specifically, it is a measure of how a change in interest rates changes the value of an option. Option values decrease when interest rates increase, and vice versa. However, interest rates have a very small impact on price so it is more important to be familiar with the delta, theta, vega and gamma.