Put Option Pricing Variables Explained

by Wes Bridel on May 13, 2011

in Stewardship

Put Option pricing has several important factors.  We began looking at these on Monday.  Today, let’s examine another way that option prices vary so that you can better understand selecting the right option for you….

Put Options for Mar 19 2011

Strike Last Change Bid Ask Volume Open Int

20 0.54         -0.01          0.52 0.53 62                     2,414

You can see that you would be paid much more ($54) to sell the same $20 Put Option on Intel with a March 19th Expiration Date.  Remember, the longer the time till expiration, the more valuable the option is because there is more chance that the stock price can move into range in that time.

$54 is a lot more than $38.  However, if you sell 4 of these options over the next year, you’ll only receive $216 for the year (which was less than selling 6 2 month options over the same time period).

Of course, in real life, the price and value of options will change over time because volatility will change so we can’t know for sure exactly what you’ll get over the course of the next year.  But if you know that volatility is very low as it is in all the examples above and you believe that volatility will increase over the next year, it probably makes sense to sell shorter dated options so that you can sell a new set when volatility is higher.  It might also make more sense to not sell any Put Options in a very low volatility environment because it probably means a time of higher volatility (and lower prices) is coming soon.  Thus waiting might yield a higher income, a lower strike price, and a smaller chance of your option being exercised.

The opposite is true as well.  The absolute best time to sell options is when there is panic in the air because the market has dropped so low that everyone is afraid to hold a long position.  If you start to sell Put Options when you feel the market is at or near the bottom, you can produce a lot of income for yourself between that date and the time when the rest of the market settles down.

Using what you’ve learned above, you’ll need to select options based on strike price and time till expiration to fit your needs.  Obviously, you want to highest yield with the smallest risk.  The degree to which you want to own the underlying stock will also influence your decision.

Also, remember that most options expire worthless.  This is the beauty of these trades.  In most environments, you are very likely to receive a nice stream of income for a long time before ever having to buy the stock.  Unless, you really want to own the stock soon because of the amazing growth potential it has, this can be a far more profitable trading strategy than outright owning the stock.  And the worst case scenarios are that you either buy the stock for less than you wanted to, or that you were paid to not buy the stock.  Those are both profitable outcomes!

This is Post 8 of a new series on stock options which we’ll be revisiting every few days.  You can find the first few parts at the following links: Pt 1, Pt 2, Pt 3, Pt 4, Pt 5, Pt 6, & Pt 7.

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