Option Valuation - Finance

Option Valuation

An option is a contract, or a provision of a contract, that gives one party (the option holder) the right, but not the obligation, to perform a specified transaction with another party (the option issuer or option writer) according to the specified terms. The owner of a property might sell another party an option to purchase the property any time during the next three months at a specified price.

There are two options which can be exercised:

^v   Call option, the right to buy is referred to as a call option.

^v    Put option, the right to sell is referred as a put option.

There are two types of options: the European options, which can be exercised only at expiration, and the American options, which may be exercised any time prior to expiration.

The American option offers greater flexibility and hence its value, in general, is greater than the European one.

At this point, we are examining options on stocks that are not paying any dividends. When a stock pays a dividend then the value of the stock drops on the ex dividend date. This predictable drop in the price of a stock will have an effect on the price of the options on that stock.

Factors Affecting Value Of Options

•   Price – value of the call option is directly proportionate to the change in the price of the underlying.

•  Time – as options expire in future, time has an effect on the value of the options.

•   Interest rates and Volatility – in case where the underlying asset is a bond or interest rate, interest rate volatility would have an impact on the option prices.

Properties of Option Values

1. The minimum value of an option is zero.

This is because an option is only a choice, not an obligation. The value of an option cannot be negative, because you do not have to do anything to get rid of it. The option will always have a zero, or a positive value.

2. The maximum value of a call option is equal to the value of the underlying asset.

This makes a lot of economic sense. An option allows you to buy a given asset at a certain exercise price. The most valuable option will be the one that allows you to acquire the asset at no cost, and the value of this option will be equal to the value of the underlying asset.

3. The total value of an option is the sum of its intrinsic value and its time premium.