Friday, July 20, 2012

Options 2.0 – Part 3. The Valuation of Options


The original column has been published in Dutch on July 18 at  DFT.nl / Goeroes / Opties 2.0 – deel 3. De waardering van opties

Valuing Options?
In our previous article of 27 June, "Options ... what are they again?", you read about the basic features and concepts of options. From the various options classes to the different expiration cycles and the value of options. Today we’ll tell you more about the valuation of options.

Options Value:
An option’s value depends on a number of fixed basic attributes, in addition to a number of variable parameters. The fixed attributes include:
- Option Type; Call or Put
- Expiration Date
- Exercise price

Option Type; Call or Put
The option type is always fixed. In Amsterdam we can choose from Call and Put options.
Call options are worth more at a higher underlying asset price.
Put options are worth less at a higher underlying asset price.

Expiration Date
The expiration date of an option is also fixed.
In the case of monthly options, the expiration date is normally the third Friday of the month. For weekly options, it is every Friday.
In the case of American style options, those with an expiration date that is further away are worth more, or at least the same, as options with an expiration date that is closer.
This doesn’t apply to European style options. An expected dividend can, in some cases, lead to a lower value for an option with an expiration date that is further away.

Exercise Price
The exercise price (strike price) of an option is fixed.
Call options with a higher strike price have a lower value than Call options with a lower strike price.
Put options with a higher strike price have a higher value than Put options with a lower strike price.

Parameters that affect premium formation :
There are also a number of variable parameters that influence the premium’s formation. These are:
- Price of Underlying Asset
- Remaining Maturity
- Interest Rate
- Volatility
- Dividend

Now let’s see exactly what effect these parameters have on an option’s value and how we can handle this.

Price of Underlying Asset
The price of the underlying asset fluctuates. And consequently, so too does the value of options.
At a higher price of underlying asset, Call options increase in value.
At a higher price of underlying asset, Put options decrease in value.

Remaining Maturity
The remaining maturity of an option changes on a daily basis. You can easily calculate the remaining maturity by determining the number of days from the current date to the expiration date.
For both Call and Put options, the option’s value will decrease as the expiration date approaches and the remaining maturity becomes shorter.

Interest Rate
The interest rate used in the valuation of options, is the interest rate for the currency in which the options are traded. In Amsterdam, Index and Stock Options are listed in Euros. The interest rate used for these options is the Euribor.
This interest rate influences the formation of an option’s price.
In the case of a Call option, the interest rate has a positive effect on the value of the Call option. A higher interest rate translates directly into a higher Call option premium.
For a Put option on the other hand, interest rates have a negative effect on the value of the Put option. A higher interest rate, therefore, translates into a lower Put option premium.

Volatility
The Volatility or movement factor is the most important parameter influencing the formation of options premiums.
In both Call and Put options, the Volatility has a positive influence. Higher Volatility translates directly into both a higher expected value and a higher option premium.
To get an idea about the level of volatility, you can always take a look at Historical Volatility. This is an indicator calculated on the basis of historical underlying asset prices.
The options market also works with an Implied Volatility, which is also known as Implicit Volatility. This Volatility indicator gives the precise Volatility level of an option, based on the assumption that its theoretical value equals the option’s current market price; because as you know, the market is always right.
Volatility can vary per options series.
It’s important for options investors to have a full picture. So make sure you’re well informed up front. That way, you’ll know if you’re buying or selling at a relatively expensive or inexpensive price.

Dividend
A (expected) Dividend before expiration affects the value of an option.
A (expected) Dividend after expiration does not affect the value of an option.
If a stock goes Ex-Dividend before the option expires, this will affect the share price and hence the value of the option.
At a higher (expected) Dividend, a Call option will decrease in value. This is because the stock price drops further, resulting in a lower value for the Call option.
At a higher (expected) Dividend, a Put option will increase in value. This is because the stock price drops further, resulting in a higher value for the Put option.
Predicting or forecasting Dividends is notoriously difficult. Fortunately, there are specialist services that stay on top of this, closely following the stock market on a daily basis and adjusting expectations according to the current situation / information available.
With options it’s important to take the correct Dividend amount, and perhaps even more importantly, the correct Ex-Dividend date, into account. If a Dividend falls immediately before or directly after expiration, this will certainly have a significant influence on the price of options.
Be careful. Expected Dividend, before expiration, is already reflected in the price of an option!
On the Ex-Dividend date you’ll notice that the share price is reduced by the dividend amount, but that the price of Call and Put options remain more or less comparable, because the Dividend has already been included in the price.

This completes our brief overview of parameters affecting the premium formation of options.
It is conveniently summarised in the table below:

Parameters
Trend
Call Option Value
Put Option Value
Price of Underlying Asset
Higher
Higher
Lower
Remaining Maturity
Decreases
Lower
Lower
Interest Rate
Higher
Higher
Lower
Volatility
Higher
Higher
Higher
Dividend
Higher
Lower
Higher


Options ... know your Greeks
In this article we covered the parameters that influence the value of options. It’s crucial that options investors estimate this correctly. Because unlike stocks, options don’t react 1:1. So options investors must trade shrewdly and on the basis of sound information. And that’s perfectly possible. The Greeks can help you with this. Yep, the Greeks! The Greeks are sensitivity factors that indicate how the value of an option will react to a change in one of the parameters. You, as an options investor, can use them to effectively look ahead. We’ll explain this in more detail in our next article.

Herbert Robijn is founder and director of FINODEX (www.finodex.com). FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.