Why Options Pricing Theory is Important to Your Trades

When options pricing theory is discussed, many retail traders’ eyes start to glaze over, or they click elsewhere. Traders will ask, “why does options pricing theory matter to me – isn’t it just complicated math for quant geeks?  Don’t I just need to figure out if a stock is going up or down to make money with options?” Understanding the basics of options pricing theory is more important than you might think. Have you experienced any of these situations:

• The stock price moves in your direction, and you lose money on your options
• The stock price moves against you and your options increase in value
• The value of your out of the money option decreases at an accelerating pace the closer you get to expiration
• The value of your option changes rapidly the closer you get to expiration and the strike price of your option

You don’t need a PhD in financial mathematics to understand how these situations (and many more) are explained by options pricing theory. Understanding a few basic concepts, in plain (ok relatively plain) English can significantly improve your return on capital and ability to find, plan and manage trades.

What Factors Determine an Option’s Value

Black – Scholes is the most well-known financial model for valuing options.  It considers six risk factors or inputs to value an option.  Changes in these factors (in combination with each other) over the life of a trade change the value of your options and ultimately determine your profitability. The six factors are:

• Time to expiration
• Stock price
• Expected volatility
• Strike Price
• Expected Dividends
• Expected interest rates

Let’s review how time to expiration, the stock price and expected volatility can impact the value of an option.  Dividends and interest rates play a smaller role.  The impact on option value of the strike price relative to the current stock price is pretty easy to see.

How Does Time to Expiration Impact Options Value

Common sense applies here – as you would expect, the longer the time to expiration, the more valuable the option due to the increased probability that the option will finish in the money. Assuming other inputs don’t change, the option will lose value as it moves closer to expiration. One of the most important applications of this concept is that an out of the money option will lose value at a faster and faster rate as expiration approaches due to this time factor. This can result in your option losing value (or not increasing in value as much as expected) as expiration approaches even if the stock price is moving in the direction of the trade. 

How Do Changes in the Underlying Stock Price Impact Options Value

Again, the basic concept is pretty straightforward:  the more the stock price moves in the direction of the trade, the more valuable the option becomes. There are a few nuances that are important to your trading. The longer the time to expiration, the less impact stock price changes will have on option value.  More importantly, the closer to expiration and the closer the stock price is to the option strike, the more impact stock price changes will have on option value. If you have an option, approaching the last few days to expiration and the stock price is close to the strike price, the option value will start to change almost in lock step with the stock price. One minute the option will look like winner, the next minute it may not!

How Does Volatility Impact Options Value

The higher the expected (implied) volatility, the more valuable the option as the probability that the option will finish in the money increases. There are a few considerations for trading. An option purchased when expected volatility was relatively high (compared to historical volatility) can lose value if volatility decreases significantly even if the stock price moves in the direction of the trade. A significant increase in expected volatility can increase the value of an option even if the stock price doesn’t move or even moves against the trade. In addition, changes in volatility will have a greater impact on option value the further out the expiration.

There are a few steps you can take to better understand these concepts. First, paper trade and monitor how changes in time, volatility, and stock price impact the value of the option. Experiment with options with different strikes, expirations, and volatility levels. Second, if your platform has simulation capabilities, change these parameters for real or paper trades and analyze the impact. Finally, document and track these key inputs for all your real trades.