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Fundamentals of Option Valuation Video

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  • 0:02 Derivatives
  • 1:16 Options
  • 2:54 Option Pricing
  • 5:28 Lesson Summary
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

Option contracts are derivative financial instruments that obtain their value from an underlying asset - usually a stock. In this lesson, we'll discuss the components that are involved in determining the exact price of an options contract.

Derivatives

One share of XYZ stock may cost $45. Depending on a couple factors, the cost of an options contract for XYZ may be anywhere from $0.05 to $75, or higher. To understand why, we need to talk about the fundamental basics of pricing options. To do that, we need to first understand financial instruments called derivatives.

Derivatives are financial instruments, like options, that get their value from a different asset, called the underlying asset. You may have heard 'oil futures' discussed around the office or on the news. Oil futures are another kind of derivative that gets their value from a barrel of oil. If you buy an oil futures contract, you aren't buying a barrel of oil, but you are buying a contract to buy oil at a later date. So, the oil future is a derivative that gets its values from oil.

Options are derivatives, and for the examples we'll use in this lesson to highlight how options are valued, we'll talk about options with an underlying asset of stock shares. For simplicity's sake, we'll focus on call options, those options that give you the opportunity to buy stock at a future date for a predetermined price.

Options

As mentioned earlier, option contracts (often just called options) are contracts to purchase something at a future date, also called the expiration date, and at a future price agreed upon when the contract is written, or the strike price. When you buy an option, you aren't going through the process of actually writing a contract (all that has already been done), and after it has been done, it trades on a market just like a stock.

You might log into your brokerage account and search for some XYZ options. You'll have an option to look at calls or puts, and remember, for this lesson, we are focusing on calls. Everything we say also applies to puts, it's just with puts you are buying the option to sell the stock, not buy it like you are when you buy a call. One more easy definition so we can have this conversation: The spot price of any financial instrument is the price at which it is currently trading. So, if you want to know the spot price of your favorite stock, just look it up on a finance website and that's the spot price.

For fun, let's think about an option for XYZ that has an expiration of May 2016 and a strike price of $50. Those would probably cost you about $3 a share, or $300 for a contract. So, what needs to happen to XYZ for you to make money? It's currently at $45, so if you want to make money by buying it at $50, you need it to climb to at least $53 per share, right? After all, don't forget the $3 per share you paid for the option you need to make up. Anything above that at any point between now and May 2016, and you'll make money.

Option Pricing

With that background behind us, let's talk about the four components of options pricing. It's important to note that while we are going to talk about this at a basic level, the practice of pricing options is far from simple. Entire books and algorithms are written to price options and then look for options that are incorrectly priced.

Now, why did that option for XYZ cost you $3 per share if the strike price was $50 but the spot price is $45? Why would you pay $3 for the opportunity to pay $50 for shares in May 2016 that cost $45 now? Probably because you think the price in May 2016 will be higher than $50 (significantly higher) and you don't want to tie all your capital up in actually owning the stock.

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