There Are Five Factors That Will Determine the Exact Value of a Call

Valuing Options

There are five factors that will determine the exact value of a call. 1. The Strike Price 2. The Expiration Date 3. The Price of the Stock 4. The Interest Rate 5. The Volatility of the Stock

The first two factors are established when the call is written and do not change over the life of the call. The third and fourth factors are easy to find, but of course, change regularly. The fifth factor is the challenge.

The Strike Price A call is an option to buy. It is good to be able to buy at a lower price, so the lower the strike price, the more valuable the option.

The Expiration Date With an American Option, you can exercise the option at any time up to the expiration date. If there are two otherwise identical options and one has an expiration date a month later than the other, the one with the later expiration date has a longer time to fall in the money. Thus, it is more valuable.

The Price of the Stock If a call option is in the money, you can always turn around and sell it immediately after you exercise the option. Thus, the higher the price of the stock, the more you will get for selling it, and the more valuable the option is. Remember, that if the option is in the money, its value, when exercised, equals the stock price minus the strike price. So, a higher stock price means a greater value. If a call option is out of the money, the higher the price of the stock, the closer it is to being in the money. Either way, a call option is more valuable if the price of the stock is higher.

The Interest Rate Since the owner of a call option doesn’t have to purchase the stock until he exercises the option, he keeps his money for a while. This is a more important feature when interest rates are high. Thus, calls are more valuable when interest rates are high and less valuable when interest rates are low.

The Volatility of the Stock The more volatile the stock is, the more valuable the call option is. To see this, draw the normally distributed returns for two stocks where each have the same expected return, but one has a higher standard deviation than the other. Since the owner of a call will not exercise his option on either stock if the price of the stock is below the strike price, we need only concern

1 ourselves with the right-hand side of the distributions. The stock with the higher standard deviation has greater opportunities for a high price than the stock with the lower standard deviation. Since a higher stock price makes the call more valuable, a call on a stock with greater volatility will be priced higher than one on a stock with less volatility.

Valuing Puts The same five factors determine the value of a put.

Strike Price Since a put is an option to sell, a high strike price (option to sell at a high price) is more valuable than a low strike price.

Expiration Date As with a call, the longer you have to exercise your option, the more valuable it is. Thus, puts are more valuable with more distant expiration dates.

Price of the Stock Since you are selling at a predetermined price when you exercise a put, you want the value of the thing you are selling to be low (buy low and sell high makes you more money!).

Interest Rate Since you won’t receive your money till you exercise your option and sell the stock, it is worse to wait for money when interest rates are high. So, the value of a put is higher when interest rates are low.

Volatility of the Stock Just as with a call, we are only concerned with one side of the distribution of stock prices (this time it is the left-hand side). The stock with a higher standard deviation of prices will be more likely to have a low price, and thus fall in the money (or further in the money).

Any formula to price an option needs to consider these five variables which determine the value of an option.