How to Value Stock Options
- 1). Review the definition of a put option, call option, and strike price. A put option is the right, but not the obligation, to sell a stock. A call option is the right, but not the obligation, to buy a stock. Investors buy put options when they think a stock is trending down and call options when they think the stock is trending up. The strike price is the price the investor believes the price will go to (down for a put, and up for a call). If the option does not reach the strike price, the option will expire worthless.
- 2). Review the Black-Scholes (1973) equation for calls and puts. In their 1973 journal article, The Pricing of Options and Corporate Liabilities, Fischer Black and Myron Scholes published an option valuation formula known as the Black-Scholes model. It is the standard model used to calculate the price of an option. The formula is: C = S N(d1) - X e-rT N(d2) where S is the value of the underlying asset, X is the exercise price in dollars, and T is the time to expiration. We will let an option pricing calculator help with this equation.
- 3). Understand the term "option premium." The option premium is the intrinsic value of the option, plus a time value (includes both time and volatility).
- 4). Review the definition of intrinsic value. The intrinsic value of the option is the amount the stock is "in the money" or over the strike price. The calculation is: current price - strike price (call option) and strike price - current price (put option).
- 5). Calculate the time value. This is a value placed on the possibility for the stock to appreciate in value. The less time an option has to expiration, the lower the option's time value.
- 6). Work through an example. If the intrinsic value of a call option is $10 and the time value is $5, then the premium is:
Premium ($15) = Intrinsic Value ($10) + Time Value ($5). - 7). Use the Black-Scholes option pricing model to find the time value. Using the equation presented in Step 1 is a long an involved process. Instead, traders can use one of the dozens of option pricing calculators available on the Internet. To use the calculator you will need to know the share price of the stock, the dividend yield of the stock, the expiration date (time to maturity), the strike price for the option and the interest rate. See Resources for a link to a pricing calculator.
- 8). Calculate time value. Input the variables and choose Option Value for the output. Select calculate. This is the premium or value of the option. Plug this into the formula put forth in Step 5, premium = intrinsic value + time value, in order to get the time value.
