Options pricing models use five factors to determine an option’s theoretical value:
- Stock or ETF price
- Strike price
- Time to expiration
- Interest rates (minus dividends)
- Volatility of the underlying stock
For shorter-term options, it is common to use an interest rate that approximates the risk-free interest rate. Most people use the U.S. Treasury-bill rate (90-day).
Pricing longer-term options is more difficult than pricing shorter-term options. To price a LEAPS® option, it is necessary to predict volatility (expectation of price fluctuation) of the underlying stock and interest rates for up to 2-½ years. Of the factors mentioned, interest rates play a more significant role in the pricing of longer-dated options due to the length of time. As a result, even professionals struggle to quote prices for options with maturity dates far in the future. The predictability of the inputs is more unreliable than for shorter-term options. Changes in implied volatility can also significantly alter LEAPS® options’ premiums.
Despite difficulties, exchange policies generally require market makers and specialists to offer quotations (both bid and offer) for up to 10 contracts. This allows investors to find a market for LEAPS® at any time.
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Content licensed from the Options Industry Council is intended to educate investors about U.S. exchange-listed options issued by The Options Clearing Corporation, and shall not be construed as furnishing investment advice or being a recommendation, solicitation or offer to buy or sell ant option or any other security. Options involve risk and are not suitable for all investors