How to Determine the Price to Pay for a Call Option
Mathematicians have developed pricing models and formulas to determine how much a call option should cost. Unfortunately, you do not get to decide how much to pay for a listed call option. The market forces of supply and demand set the prices of options, and your choice is which option to buy at the current price. What you can do is use some probability calculations to get an indication of whether a specific call option will be a profitable trade. This information will help you choose from the large number of different call options available on any stock.
Select a stock you think will go up in value. This is the critical decision when buying call options, since calls gain value if the underlying stock increases in price. Your stock selection criteria could be based on fundamental or technical analysis, such as a company that has posted several recent quarters of better-than-expected sales and earnings growth or whose stock price has been on an extended upward trend. Buying call options on a hunch is not the ticket to option trading success.Step 2
Calculate the probabilities of whether your selected stock will reach different strike prices where a call option purchase would be profitable. Many online brokerage companies provide Web-based calculators that let you enter the current stock price, expected volatility and days to option expiration to calculate the percentage probability that the stock will reach a selected price. For example, suppose you set a target stock at $100. The calculator might show a 45 percent probability to reach $102, a 35 percent probability to reach $105 and a 20 percent probability of exceeding $110.Step 3
Compare call option prices at different strike prices with the probabilities to develop a profit potential matrix. The higher the option strike price, the lower the cost. However, a higher strike price option also has a smaller probability of becoming a profitable trade. The conservative choice is to pay more for a call with a lower strike price. The probability figures show the smaller chance that a cheap call option will end up profitable.Step 4
Make your final call option selection based on your analysis of where you think the stock price will go before the options expire. You might decide to go with the more expensive calls with a lower strike price and higher probability of reaching the strike price. Or you might go with the cheaper option with a lower probability of success but a much higher payoff percentage if the stock does take off to the upside.
- Available volatility data includes historical values based on past stock price movement and implied volatility derived from current option prices. Your brokerage account options trading section will provide both values for any stock and several time frames.
- The strike price of a call option is the price at which the contract can be exercised to buy the underlying stock. A call option purchase is profitable when the stock price is above the strike price by more than the price paid for the option.
- The probability calculation of hitting a certain price does not take into account any price trends or other factors which might move a stock either up or down. It is strictly a mathematical calculation based on time and volatility.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.