Options Guide

Pricing

Options pricing models contain five factors that are used to determine a theoretical value for an option: stock price, strike price, time to expiration, interest rates (less dividends) and volatility of the underlying stock.

With shorter-term options, it is fairly straightforward to use an interest rate which approximates the "risk-free" interest rate; most people use the U.S. Treasury-bill rate (90-day). However, to price a LEAPS® option, it is necessary to predict the volatility (expectation of price fluctuation) of the underlying stock and interest rates over 2 ½ years; this is difficult even for most professionals.

In short, pricing longer-term options is more difficult than pricing shorter-term options. Of the five factors mentioned above, interest rates play a more significant role in the pricing of longer-dated options, due to the length of time involved. For these reasons, professionals are not ready to instantly quote prices of options with maturity dates far into the future, since the predictability of the inputs is so much more unreliable than for shorter-term options.

Despite these difficulties, investors will find that 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® whenever the decision is made to use them.

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