Education 03: How are Options Prices determined?
Traded like stocks....
Option contracts are traded like stocks. This means that there is no set "selling" price, but the price is determined by the market. The market refers to buyers and sellers who come together to exchange their holdings for cash. When more buyers come to the market, it pushes prices up as the buyers have to bid higher in order to entice sellers. And if more sellers come to the market, they have to offer lower prices to entice buyers to buy their holdings.
Example: If you own a car dealership, and you have 100 BMW's on your lot, and a BMW normal sells for $70,000. If your normal inventory is 50 vehicles, it will be hard to sell all 100 BMW's you currently have. So, you would lower the price some to attract more buyers.
Now, if you have only 20 vehicles, you don't want to be out of inventory and you want to make the best profit you can, so you won't sell any vehicles for less than $70,000 and will probably raise the prices even higher.
So, when you hear the phrase "The market determines the price", it is referring to the dynamics between buyers and sellers. These dynamics are constantly changing, that is why prices move constantly during the day.
Option Prices, continued...
While Option Prices are determined by the market, there are still some variables that determine what that option price should be. These include:
- Where the stock price is in relation to the Strike Price
- How much time is left before expiration
- How volatile are the stock markets
- How volatile is the individual stock for the option you have
All of these factor into what traders feel is the appropriate price for an option. The action between these traders is what results in the "Market Price". Sometimes, the market prices will get out of line, or become too different from what the prices should be. During these times, traders will take advantage of that discrepancy until the market prices gets back to where they should be.