Understanding Option Pricing

12/11/2007 12:00 am EST

Focus: OPTIONS

Beginning traders are often urged to limit their initial trading activity to the purchase of options, buying a call option if prices are expected to rise and buying a put option if prices are expected to fall. Options have the primary advantage of limiting downside risk: for any option that is purchased, the most that can be lost is the premium (or cost) of the option plus commission and other transaction fees. When it comes to putting this strategy into practice, however, many beginners become frustrated in their attempts to translate the string of numbers that they might pull down from the internet into a sensible option price. In this article, I will explain how to read option prices.

Generally, option prices are quoted in ticks or minimum price fluctuations. The dollar value of a tick can vary from market to market and is described in the contract specifications for that market. (This, in turn, is set by the exchange on which the contract trades.) At first, you will have to do a little studying of tick values but in time, you will come to know the common ones by memory. Let’s look at some typical option prices for example.

Gold Options:
One tick in the gold options market is $0.10 per ounce and has a value of $10. With June gold futures at $283.50 per ounce, for example, the June gold call option struck at 285 may be trading at $4.10 per ounce, or 41 ticks, which is equal to $410.

Bond Options:
One tick in the bond options market is 1/64 of a point and has a value of $15.625. With June bonds futures at 96-29, for example, the June bond call option struck at 96 may be trading at 1-38 or 102 ticks equal to $1,593.75. (Bond option prices are expressed in 64ths of a point, so 1-38 means 1 + 38/64 = 102/64.)

Sugar Options:
One tick in the sugar options market is 0.01 cents per pound and has a value of $11.20. With July sugar futures at 6.52 cents per pound, for example, the July sugar call option struck at 650 may be trading at 36 ticks which is equal to $403.20.

Cocoa Options:
One tick in the cocoa options markets is $1 per ton and has a value of $10. With July cocoa futures at 885, for example, the July cocoa call option struck at 850 may be trading at 67 ticks which is equal to $670.

When pulling option prices down from the internet that originate from the exchanges themselves, a decimal may or may not be shown in the option price. This is mainly a feature of the price reporting software of the exchanges, and it will make interpreting the price a little more difficult. However, if you know what price to expect, then it won’t present a problem. In most cases, you can disregard any decimal that may exist and consider the number to be in ticks. Multiply this number by the tick value to calculate the option price.

When calculating option prices, use the following to roughly check your answer.
1. Call options become less expensive the higher is the strike price.
2. Put options become more expensive the higher is the strike price.
3. Call and put options become more expensive the longer the time to expiration.
4. For most markets (not including the equity index markets), the value of an at-the-money call or put option with one month to expiration usually falls between $400 and $1,500. If your calculation produces a price far outside of this range, you may have an error.

If you have a trading account, or even a paper trading account, you may be able to contact your broker to confirm your calculation of an option’s price and I advise you to do so, especially the first few times. After a little practice, you should be able to read option prices quickly and easily and you can then move on to the next step: selecting the proper strike price, which is the topic of the next article.

Rick Thachuk is President and Co-Founder of World Link Futures, Inc., a registered educational Commodity Trading Advisor serving the beginning futures, options and FOREX trader. http://www.worldlinkfutures.com

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