Valuation components of a (stock) option

So I’m trying to make a visual aid to teach noobs what drives the value of a stock option. I listed a sample breakdown of the factors below. How would you edit this?

  1. Instrinsic Value

a) Strike Price

b) Market Price of Underlying asset

  1. Time Value

a) time remaining until expiration

b) Volatility of underlying asset (goes here?)

With that said, where should I put

  • Dividends
  • Risk free rate of return

In this little org chart? Would dividends and RFR/interest rates go under 1? Under 2? Or would they be 3 and 4?

I’d put dividends under intrinsic value (when dividends are paid, the market price of the underlying drops, so the intrinsic value changes), and I’d put the risk-free rate under time value (because the time value is the present value of future price changes, and the present value depends on the risk-free rate).

I’d also be sure to specify whether the volatility of which you speak is volatility of price or volatility of returns; they’re quite different.

volatility of underlying asset price

as the asset is more volatile, it increases the chances of the option getting “deep in the money”. At least that’s what I meant. You got a diff take?

You did it again: the _ asset _ isn’t volatile (unless the asset is, say, nitroglycerine). Its price is volatile. Its returns are volatile. It isn’t.

For what it’s worth, in the Black-Scholes-Merton model, σ is the standard deviation of the asset’s _ returns _, not the standard deviation of its price.

That is an important distinction that I didn’t think about, and I will make the adjustments. Thanks again.

https://docs.google.com/file/d/0B78Jt3VIkVtnS3NUbG0xcGpLems/edit?usp=docslist_api

Here’s a screenshot of a real Option Chain on GOOG. It’s easier to understand once you apply it instead of just memorizing relationships. The Calls are on the left and the Puts are on the right.

Also if you organize it in terms of “the Greeks” it might be a little more useful and applicable in the real world.

The Greeks don’t appear in the CFA curriculum until Level II, whereas at Level I they cover intrinsic value and time value. Both organizations are probably useful.

I’m confusesd by that pic. It lists different variants of a stock option (different strike prices) but not the premium price.

btw, what app is that?

It’s thinkorswim by TD Ameritrade. I left the Bid/Ask off so you could just see the components that affect the pricing of the option.