OPTION-PRICING MODEL FACTORS

• Expected Term

• Volatility

• Exercise Price

• Fair Market Value

• Dividend Yield

• Risk-Free Interest Rate

WHAT IS THE EXPECTED TERM?

Expected term is the period that option is expected to be outstanding. 

• The expected term refers to the period during which the option is anticipated to be outstanding, i.e., the time between the option's purchase and or sale date and its expected exercise or expiration date. 

  • First day upon purchase and or sale date to expected exercise/cancellation. 

• Before we get any further, we should understand the difference between Fair Value and Fair Market Value. 

  • For options, the Fair Value is the value of an option using an option pricing model. 

  • The Fair Market Value is equal to the current trading price of the underlying stock.

• Longer expected term = higher fair value 

  • Longer expected term durations provide more time for the underlying asset's price to move in a favorable direction.​

WHAT IS THE EXPECTED VOLATILITY?

Volatility is a measurement of how much stock price is expected to fluctuate over the expected life of the option. 

• May be based on: 

  • Company's own historical volatility (public companies often use historical volatility rates).

  • Implied volatility (volatility associated with exchange-traded options on company's stock over the expected term of the option)

  • Volatility can be estimated using historical data, implied volatility from option prices, or a combination of both.

  • Note: some models assume that the volatility will remain constant during the lifetime of the option which isn’t likely the case in a real scenario. Be sure to know the limitations of the mode used. 

• Private companies without an internal market for their shares generally use peer company volatility or industry indices.

• Higher volatility = higher fair value 

  • Higher expected volatility increases the likelihood of significant price swings, which in turn increases the probability of the option ending up "in the money."

WHAT IS THE EXERCISE PRICE?

Exercise price also known as the strike price, is the price at which the option holder can buy (in the case of a call option) or sell (in the case of a put option) the underlying asset. 

• Smaller spread = lower fair value 

  • A smaller spread between the exercise price and the current price of the underlying asset leads to a lower fair value of the option. This is because options with lower exercise prices are more valuable to the holder since they allow them to buy (or sell) the asset at a more favorable price. 

  • Note: Fair Value and Fair Market Value are not the same and have different understandings for determining value.

WHAT IS THE CURRENT PRICE?

Current Price of Underlying Stock (Fair Market Value - FMV) The fair market value (FMV) of the underlying stock is the current market price at which the stock is trading. 

• Higher FMV = higher fair value 

  • The higher the FMV of the underlying stock, especially in the case of call options, the higher the fair value of the option. This is because a higher stock price increases the potential payoff from exercising the option.

  • Conversely, for put options, higher stock prices reduce the potential payoff, leading to lower fair values.

WHAT IS THE EXPECTED DIVIDEND YIELD?

Expected dividend yield are payments made by a company to its shareholders out of its profits. They reduce the value of the underlying asset since they represent a cash outflow to the shareholder.

• Higher dividend yield = lower fair value 

  • Higher expected dividend yields lead to lower fair values of options, particularly for call options, because they reduce the potential appreciation of the stock price.

  • Note: some option pricing models don’t factor dividend yield in like the Black-Scholes Model

WHAT IS THE RISK-FREE INTEREST RATE?

Risk-free interest rate is the theoretical return on an investment with zero risk of financial loss, typically represented by government securities' rates.

• Higher interest rate = higher fair value

  • Higher risk-free interest rates increase the present value of the option's potential payoff, thus leading to higher fair values of options. This is because options have intrinsic time value, and higher interest rates increase the discount applied to future cash flows, making options more valuable.

  • Note: some option pricing models don’t account for a change in the risk-free interest rate and assume it remains constant. 

• Generally equal to treasury rates 

  • The standard generally used should really be the zero-coupon rate on U.S. government issues, however, that number is not readily accessible, so generally companies use the current Treasury rate for bills and or bonds in the given term of the option.

In conclusion, the valuation of options in the stock market is multi-layered and requires careful consideration of several key valuation factors. From the expected term and volatility to the exercise price and current stock price, each factor is independent of the next and influences the fair value of options in unique ways. When researching your next trade be sure to see how much your option is really worth.

We trust that this guide has provided you with much insight into your research for option price valuations. Whether you are an experienced investor or just starting out, please be sure to consider these valuation along with your comfortable risk tolerance when entering your next options trade. Factoring the valuations in the option pricing models is just one of the many essential steps for making an option trade successful. Remember that each of these valuations may be used differently per model. It is also good to note to review the integrity of each model as these are just financial models and that no one model is correct. Thank you for exploring this guide, and we wish you the best of luck in your options trading journey and endeavors moving forward!

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