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Essential Option Strategies by J. Kinahan

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Chapter 8Components of Options Prices

An insurance company looks at many things when setting rates for an auto policy. The insured's driving record, age, and vehicle are all factors that are considered. Some companies might give discounts to students with good grades. Others charge more for convertibles or sports cars. If you have several speeding tickets, you can expect to pay more in auto insurance as well.

Similarly, share prices of companies that move very fast typically have higher options premiums than slow-moving ones. This is similar to how volatility works. Why? Consider two stocks: XYZ and ZYX. While XYZ has been trading in a range between $30 and $40 per share during the past twelve months, ZYX has been in a range between $20 and $90. If both stocks are currently trading for $35, which one is more likely to move to $60 during the next twelve months?

All else being equal, a volatile stock will have higher options premiums because the options have a higher probability of being in the money (ITM) at expiration. That is, a 60-strike call on ZYX has a higher probability of being ITM at expiration, because the stock has been trading between $20 and $90 during the past year, and XYZ has been in a range between $30 and $40.

In addition to the speed or volatility of the underlying, other determinants of options prices include the price of the stock, the strike price of the option, the time left until expiration, dividends paid, and current interest rates. These components ...

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