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What Is Involved in an Option Valuation?

Jim B.
Jim B.

Option valuation, which is the process of trying to determine the worth of the investment vehicles known as stock options, is one of the most difficult tasks in investment analysis. That is because there are many factors involved, including the fact that the option derives part of its value from the price of an underlying stock. In addition, option valuation must include some sort of allowance for time, since options can be held for a length of time before their expiration date. Perhaps the simplest way to value options is to take a percentage of their intrinsic value, which is the amount of shares in the option multiplied by the price at which the option may be exercised.

Unlike stocks, which have their value clearly defined by their current price, options can be confusing in terms of how much they are actually worth. Since an options contract can be bought for just a small percentage of the price of the underlying stock, many investors see options as a way to make significant money through a relatively small investment. But they must first come up with some method of option valuation to avoid losses.

Man with hands on his hips
Man with hands on his hips

Any method of option valuation begins with understanding how options work. A person who buys an option contract earns the right to buy 100 shares of an underlying stock with a call option. He or she can also sell 100 shares of such a stock with a put option. These options may only be exercised when the stock's price reaches a so-called strike price, which is determined at the outset of the option, and only before the contract's expiration date.

All of these characteristics come into play with option valuation. The predicted performance of the underlying stock is the dominant factor, since a person holding an option will benefit greatly if the stock price moves in the anticipated direction. In addition, the proximity of the current stock price to the strike price also affects value. With call options, a strike price that is far higher than the current price lessens the value of the option, since there is less chance that the strike price will be reached. Finally, an option that is close to expiring will also start to decrease in value.

Since all of these factors are a lot to grasp, those holding stock options might prefer a simpler method of option valuation. Using the intrinsic price of an option is one way to achieve this. For example, an option for 100 shares of stock at $40 US Dollars (USD) per share would have an intrinsic value of $4,000 USD, which is 10 multiplied by $40 USD. Most investment experts agree that the overall value of a new option is about 30 percent of the intrinsic value. In the example above, the option would have an estimated value of 30 percent of $4,000 USD, or $1,200 USD.

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