VALUATION

Aside from the more general forces of supply and demand, several factors affect the valuation of options. Chiefly, these are:

• The option’s strike price relative to the current price of the underlying

An option may have intrinsic value or time value. Intrinsic value is the value the option would have were it to expire immediately, i.e. for calls, the amount by which the underlying is trading above the strike price, and for puts, the amount by which the underlying is trading below the strike price. An option with intrinsic value is said to be in-the-money. Any value not intrinsic must be time value. Most traded options have no intrinsic value, i.e. are out-of-the-money. (Options whose underlyings are trading at the strike price are said to be at-the-money.)

• Interest rates and anticipated dividends

Holding positions can result in cash flows in or out. These cash flows can often be predicted to some degree and thereby affect the prices market participants require to get into those positions in the first place.                 Links

• Time until the option’s expiry

Any value an option has which is not intrinsic is referred to as time value. This is value associated with the potential for positive shifts in the price of the underlying in the remaining time. With more time remaining, there is a greater chance of the underlying moving desirably.

• The anticipated volatility of the underlying’s price until the option’s expiration

The greater an underlying’s volatility, the greater the prospect for it moving away from the current price and towards and through an option’s strike price, thereby expiring in the money. As all the other factors affecting option valuation are known, it is possible to calculate the market’s assumptions about future volatility from the prices of options trading at any one time.