Call Option - Example of Valuing A Stock Option

Example of Valuing A Stock Option

A company issues an option for the right to buy their stock. An investor buys this option and hopes the stock goes higher so their option will increase in value.

Theoretical option price = (current price + theoretical time/volatility premium) – strike price

Let's look at an actual example, PNC options for January 2012: http://finance.yahoo.com/q/op?s=PNC&m=2012-01.

• Strike price – the price the investor can buy the stock at through the option.
• Symbol – like a stock symbol but for options it incorporates the date.
• Last – like the last stock price, it is the last price traded between two parties.
• Change – how much it went up and down today.
• Bid – what a person is bidding for the option.
• Ask – what someone wants to sell the option for.
• Vol – how many options traded today.
• Open Int – how many options are available, i.e. the option float.

Notes:

1. The bid/ask price is more relevant in ascertaining the value of the option than the last price since options are not frequently traded. Meaning the value is usually the Ask/Bid Price.
2. An option usually covers 100 shares. So the bid/ask price is multiplied by 100 to get the total cost.

Let's say we bought 3 PNC strike $45, January 2012 options in August for $11.75. That means we paid $3,525 for the right to buy 300 (3*100) PNC shares between now and January 2012.

The stock at that time traded at $50.65 meaning the theoretical call premium was $6.1 as shown by our formula: (current price + theoretical time/volatility premium) – strike price, (50.65 + 6.1 – 45 = 11.75).

Today the option is worth $19.45. With a theoretical call premium now of 73 cents. The call premium tends to go down as the option gets closer to the call date. And it goes down as the option price rises relative to the stock price, i.e. the 19.45 the option is now worth is 30% (19.45/ $64) of the price per PNC shares. In August it was 23% (11.75/$50.65). The lower percentage of the option's price is based on the stock's price, the more upside the investor has, therefore the investor will pay a premium for it.

This option could be used to buy 300 PNC shares today at $45, it can be sold on the option market for $19.45 or for $5,835 (19.45 * 3 options for 100 shares each). Or it can be held as the investor bets that the price will continue to increase. The investor must make a decision by January 2012: he will either have to sell the option or buy the 300 shares. If the stock price drops below the strike price on this date the investor will not exercise his right since it will be worthless.