Une Part provided a basic overview of stock options. Time to continue along our path learning about this not-so-fun, but need-to-know topic.
There are certain components that identify a stock option’s value. Since option contracts are traded on regulated markets, their values undoubtedly fluctuate throughout the trading day. The price of a stock option is based on several factors. These include the current price of the underlying stock, the price volatility of the underlying stock, the time to maturity, and interest rates.
Let’s talk about intrinsic value. This is the difference between the exercise price and the price of the underlying security. You will make money off an option when this value is positive.
Second, we have volatility. Let’s take a moment here. If you haven’t taken a finance class, this term may be slightly confusing. Volatile means tending to rapid and extreme fluctuations. It is used to describe how big and how often a stock price fluctuates. If a stock price is highly volatile, there is a higher chance that the option will make you money at its expiration date. Thus, the option will carry a higher premium than an option on a less volatile stock.
Time, oh time. Next is time value. The more time remaining until the expiration date of the option, the greater the potential for significant change to occur in the price of the underlying security. This can result in the option gaining more value. Time value diminishes as the expiration date of the option moves closer.
Finally, we have interest rates. The option premium is a cash payment that can be invested by the seller to generate interest income. Higher interest rates allow for greater earnings.
All of these components play a huge role in the determination of a stock option’s value. Once these terms are fully understood, you will really start to understand how they affect an option’s worth.
To test it out, it may be a good idea to take a peek at the market. Head to Yahoo Finance, choose a stock, and watch it for a week or two. Record the price and price fluctuations over this time period. After comparing the numbers from your list, it should be easier to understand the stock’s volatility and value. This is a more hands-on approach to understanding the terms mentioned above. Once you realize how the stock market works, you may feel more confident when the time comes to invest. After all, it’s hard to complain when you’re making money!