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Value of a Call Option & the Fifth Factor

Instructor: David Bartosiak

Dave draws off his years of experience as a Financial Advisor and Analyst to teach others all about finance and the investing world.

This lesson will explore the factors that impact the value of a call option including the 'fifth factor', price volatility. You will learn the basics of call options pricing and come away with an understanding of volatility, time value and intrinsic value.

What Is a Call Option?

Options can be used for a variety of purposes. They can be used to create income, protect an investor from losses, or as speculative trades to try and make big money with big risk. Here we'll explore the factors that go into the value of a specific type of option, the call option.

A call option gives the option holder the right to purchase something anytime between now and the expiration date at an agreed upon price. In order to figure out what that this call option is worth, a number of factors are considered.

Let's say Sarah is looking to buy a call option on XYZ Corp stock because she thinks XYZ stock will go up over the next year, appreciating over its current $11 per share price. She decides to buy a $10 call option that expires in one year.

The value of this option will be determined by the strike price, current price, risk-free rate, time value and a 'Fifth Factor', price volatility. Let's break down each of these factors using the example.

Option Value Determinants

The strike price is the agreed upon price where the option may be exercised at any time between now and the expiration date. By choosing the $10 strike price, Sarah can buy 100 shares of XYZ Stock anytime between now and the expiration date next year. The strike price is the single largest factor in determining the value of a call option. Without this information, it's impossible to determine a value.

The current price is where the underlying instrument, XYZ stock, is currently trading. Sarah knows XYZ Corp is trading at $11 and thinks it will be worth more later this year. The difference between the current price and the strike price is known as the 'intrinsic value' of an option.

The risk-free rate is the return Sarah can get without having any risk of losing her principle. The most common thing to use for this rate is the yield on United States Treasury 3-month T-Bills because there is a very small chance the U.S. doesn't pay these obligations. The short expiration of T-Bills is used because options typically have shorter time until maturity.

Theoretically, there is no such thing as a risk-free rate because even the safest bonds carry a small bit of risk. However, barring a zombie apocalypse, the U.S. can be relied on to pay out on their T-Bills.

Sarah's call option also has time value. This is determined using the amount of time from today until when the option is set to expire. We know the expiration Sarah's option is exactly one year from now. She'll have a year's worth of time value in her option.

The further out option expiration is, the greater the time value of an option. In other words, a September call option will have more time value than a July call option (in the same year). Time value erodes slowly at first, then very quickly as an option approaches expiration.

The Fifth Factor

The 'fifth factor' is price volatility, or how wide a range people think the underlying stock will move. Volatile stocks or high beta stocks can move several percentage points on any given day. The price volatility of an option tries to put a price on the expected range a stock will move between today and expiration. The more wild a stock's daily movement, the larger this price volatility value will be.

Price volatility becomes a significant part of an option's value when options are trading out-of-the-money. An out-of-the-money call option is one that has a strike price that is greater than the current price.

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