Options Pricing and Options Chains
You want your options trades to be profitable, so how do you choose an options contract to buy (or sell) that will maximize your odds of profiting while minimizing your risk? There are many factors to consider when evaluating an options contract, which can make the process feel daunting.
In this article, we'll talk about the variables that help determine the price (premium) of an options contract. We'll also look at an options chain, which is an invaluable tool for gathering information about the available options contracts for a specific security.
Options Trade Components
First, let's review the components of an options trade.
A buy order for an options contract might look something like: 1 NVDA October 18, 119 call for $6.35
The six components of this trade are as follows:
Quantity: 1 options contract is being purchased, representing 100 shares of the underlying asset.
Underlying Asset: NVDA is the stock that will be bought or sold if the options contract is exercised.
Expiration Date: October 18 is the expiration date of the contract; if the contract buyer wishes to exercise their option and buy 100 shares at the strike price, it must be done by October 18th.
Strike Price: 119 is the strike price of the contract; this is the amount the contract buyer will pay per share of NVDA if they exercise the contract.
Contract Type: Call is the type of options contract, which gives the contract buyer the right to buy NVDA shares at the strike price; if they wanted to buy the right to sell NVDA shares at the strike price, they would purchase a put option instead.
Premium: $6.35 is the per-share premium/price of the options contract. Note: each contract controls 100 shares of the underlying asset, so the cost would be $635 plus any transaction fees.
One of the key pieces of information you need to provide when placing an options trade order is the premium. Buyers pay the premium in order to have the option to exercise the contract later, and sellers collect the premium in return for taking on the risk that they'll have to fulfill the contract terms when the buyer exercises the contract, even if that results in a loss for the seller. Choosing the right premium is key to making a successful options trade.
Options Premiums
Because options contract sellers make money by collecting the premium from the options contract buyer, the premium tends to increase as the seller's risk of losing money increases. If they take on high risk, they demand a high premium to offset that risk.
Therefore, any factors that tend to increase the risk of the seller losing money will likely result in higher premiums for the options contract.
The three main variables that impact the price (premium) of an options contract are:
Moneyness: the relationship between the underlying asset's price and the strike price
Implied Volatility: how much the security's price is expected to move over a specific time period
Expiration Date: the number of days left until the contract expires
Let's take a closer look at each of these important concepts.
Moneyness
The "moneyness", or the relationship between the strike price of the options contract and the price of the contract's underlying asset, plays a huge part in the cost and outcome of an options trade.
The moneyness of an option is determined by whether the strike price of the option is higher, lower, or the same as the price of the underlying asset. The terms “in the money” (ITM), “out of the money” (OTM), and “at the money” (ATM) are often used to describe this relationship.
In the Money (ITM) describes an option with intrinsic value for the buyer. If you exercise an ITM contract, you will get a better price than the current stock price. It’s different for call and put options:
A call option is ITM when its strike price is lower than the price of the underlying asset. The buyer will be able to buy shares at a lower price when exercising the contract.
A put option is ITM when its strike price is higher than the price of the underlying asset. The buyer will be able to sell shares at a higher price when exercising the contract.
Out of the Money (OTM) describes an option with no intrinsic value for the buyer. If you exercise an OTM contract, you will get a worse price than the current stock price:
A call option is OTM when its strike price is higher than the price of the underlying asset. The buyer will not want to purchase shares for more than the current share price, so will likely let the option expire worthless.
A put option is OTM when its strike price is lower than the price of the underlying asset. The buyer will not want to sell shares for less than the current share price, so will likely let the option expire worthless.
At the Money (ATM) describes an option with a strike price that is the same, or very close to, the price of the underlying asset.
How does the moneyness affect the premium? If the options contract buyer exercises the option while it's in the money, the seller will lose money. Therefore, the seller requires a higher premium to make it worthwhile to take on the risk of entering a contract that is favorable (in the money) for the buyer. The greater the difference between the two prices, the higher the seller's risk and the higher the premium.
But moneyness is not the only factor in options pricing, because the price of the underlying asset (and therefore the moneyness) can change before the buyer exercises the options contract or the contract expires.
Implied Volatility
The volatility, or how much the underlying asset's price changes over time, can also have an impact on the premium.
There are two types of volatility: historical and implied. Historical volatility is how much a stock’s price has deviated from its average price over a specific period, usually one year. You can compare the historical volatility of different stocks to get a general idea of how much a stock’s price moves over one year.
Implied volatility (IV) is what the market expects a stock's volatility to be in the future. It gives you an idea of how much the market price could move over a specific period. However, that move could be in either direction. For example, an options contract with an IV of 52% means that, all else equal, the stock price could move up or down by 52%.
How does the Implied Volatility (IV) affect the premium? When there is high volatility, both the buyer and seller are taking a bigger risk. If the security is prone to large price swings, there is a greater risk that the underlying asset's price will change enough to affect the moneyness of the options contract. The higher the IV, the higher the risk. The seller requires a higher premium for taking on that greater risk, and the buyer may be willing to pay a higher premium in hopes of a greater reward.
Just like the moneyness, the implied volatility is not static. It tends to decrease as the options contract gets closer to its expiration date.
Expiration Date
All things being equal, an options contract with a shorter time to expiration will usually cost less to buy than one with an expiration date that's further out. This is, quite simply, because there isn't much time for the underlying asset's price to change significantly enough to affect the moneyness of the options contract. Everybody involved has a good idea of where things are likely to stand when the contract expires.
Longer-term options, those with more than 30 days to expiration, provide more time for the underlying asset to make a bigger price move, potentially changing the moneyness. This higher risk typically comes with a higher premium.
While this is generally true, remember that the risk to the seller is ultimately what is driving the price of the options contract. Regardless of how close to expiration the options contract is, if it's in the money, and its moneyness is unlikely to change before the expiration (due to a decrease in its Implied Volatility), then the seller's risk of loss is high, and the seller will demand a higher premium to offset that risk.
As shown in the previous example, all three variables play a role in determining the pricing of the options contract, and they all should be taken into consideration when assessing a contract's premium.
Conditions Resulting in Higher Premiums
Conditions Resulting in Lower Premiums
Moneyness
In the Money contracts
Out of the Money contracts
Implied Volatility
High IV
Low IV
Expiration Date
More than 30 days to expiration
Less than 30 days to expiration
Options Liquidity
Options pricing is a major factor in choosing which options contract to buy or sell, but it is not the only factor. It is also important to consider the liquidity of an options contract. If traders have little interest in an options contract with a particular strike price and expiration date, then it may be a challenge to buy or sell that options contract in a timely manner and at a fair price. Just like when purchasing stocks using technical analysis, it is recommended to look for more liquid options contracts to invest in.
To assess the liquidity of an options contract, look at the bid/ask sizes, the volume, and the open interest for a contract. These concepts are discussed in the Options Chains section below.
Options Chains
An options chain is a table that summarizes key information about available options contracts for a specific stock or other asset. It enables you to quickly assess the premium, moneyness, implied volatility, and liquidity for options contracts of various expiration dates and strike prices.
When you first view an options chain, it can be overwhelming. There are many data points to consider, and they are constantly changing.
Cool Tip: StockCharts' options chains can be laid out with call and put data for a specific strike price shown side by side (Straddle View), or with calls and puts in separate tables (List View). You can also use the Strike Range slider above the table to limit the range of strike prices shown.
Armed with our new knowledge about moneyness, implied volatility, time to expiration, and liquidity, let's look at the different components of an options chain.
Contract Expiration Date
The expiration date of the contract can be changed on a StockCharts options chain using the dropdown menu above the table. The number in parentheses indicates the number of days until that contract expires.
Note: Expiration dates with a (W) after them are weekly option contracts. Most options contracts are monthly, but the shorter-term weekly options contracts can be used to take advantage of price moves within a specific week.
Moneyness
If an options contract is in the money (the difference between the strike price and the stock's price is favorable to the buyer), the data will be highlighted in green in the StockCharts options chain. This allows you to see the moneyness of individual options contracts at a glance.
In the money contracts tend to have higher premiums than out of the money contracts.
Strike Price
The Strike Price is the per-share price at which the buyer will buy (for a call option) or sell (for a put option) the underlying shares when exercising the options contract.
This column is highlighted in grey in the StockCharts options chain.
Bid/Ask Data
The bid/ask values in the table show the range of premiums available for that contract. The Bid is the highest premium a buyer is willing to pay for that options contract, while the Ask is the lowest price a seller is willing to sell the same contract for. The Mid price is just the midpoint between the bid and ask.
The Bid Size shows the number of options contracts investors are willing to buy at the bid price, while Ask Size shows the number of options contracts available for sale at the ask price. These numbers show the supply and demand levels for a specific options contract, and can help options traders choose a more liquid contract.
Cool Tip: If the Bid Size and Ask Size are not shown on your StockCharts options chain, make sure the Show All Columns checkbox is checked.
Volume and Open Interest
The Vol column shows the trading volume for that particular options contract on the current trading day.
The OI (open interest) column indicates the total number of active contracts in existence for that options contract. A relatively high open interest means the contract is more liquid.
Like bid/ask data, both of these measures help traders choose a more liquid options contract to invest in.
Implied Volatility (IV)
The IV column indicates how much the stock price is expected to change over a specific time period (typically one year). Remember that this measure indicates how far it may move, but not in which direction. If the IV is 17%, the price could go up 17% or go down 17%.
Options contracts with high implied volatility tend to be riskier than those with low implied volatility.
Greeks
The "greeks" are calculated values that measure the sensitivity of options contract premiums to changes in various market factors, such as movement in the underlying asset's price, implied volatility, time to expiration, and interest rates.
The Delta column shows the expected ratio between the change in the option premium and the change in stock price. For example, if the delta is 0.5, that means the premium price is expected to increase 50 cents for each dollar the stock price increases. Some traders feel that options contracts with a high delta are more likely to be in the money at expiration.
The Theta column shows the time decay of the options premium as it gets closer to expiration. It represents the cents/day that the premium is expected to be reduced by. The theta tends to get higher as you get closer to the expiration date, as the premium starts to drop more rapidly.
The Gamma column shows the expected ratio between the change in Delta and the change in stock price. It essentially measures the volatility of Delta. The highest gamma values are typically seen when the option is at the money and close to expiration. Some traders feel that options contracts with a high gamma have a lower chance of expiring in the money.
The Vega column shows the expected increase or decrease in the option's premium based on a 1% change in implied volatility (IV). This value tends to be higher when the contract is further away from its expiration date.
The Rho column shows the expected increase or decrease in the option's premium based on a 1% change in the risk-free interest rate.
Cool Tip: If only the Delta is shown on your StockCharts options chain, make sure the Show All Columns checkbox is checked in order to view the other greeks.
The Bottom Line
Options contract premiums are in large part determined by the risk the seller is taking on when entering into an options contract. The higher the risk of loss to the seller, the higher the premium. Three main variables that impact the premium for an options contract are the moneyness of the contract, the implied volatility of the option, and the number of days until the contract expires.
Liquidity of the options contract is also an important factor to consider when making options trades, as contracts with low liquidity may be more difficult to buy or sell in a timely manner and at a fair price.
Options traders use an options chain to research the moneyness, implied volatility, liquidity, and other important info about available options contracts for a specific underlying asset. Options chains are invaluable tools for choosing the right options contract at the right price.
Researching Options Contracts with StockCharts
Viewing Options Chain Information
The Options Summary shows options chain information for US stocks. To access the Options Summary, choose Options from the Charts & Tools menu, then enter the symbol you want to view options info for.
Click here to view a live version of this Options Summary
Options chain information is also available on the Options tab in both StockChartsACP and the SharpCharts Workbench. In addition, members can view options information for the symbols in their ChartList using Options View.
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