Options can be a powerful tool. And every investor should be familiar with them.

First, it’s important for beginners to forget what they “think” they know about options, especially how risky they are. Instead, remember this: All rational investors realize that there is no “sure thing” when it comes to investing. Every investment incurs at least some risk.

This risk is what the investor is compensated for when he or she purchases an asset. Mitigating that risk is where options come in.

You see, options are primarily used for two purposes: speculation and hedging.

When you purchase options as a means to speculate on future stock price movements, you are limiting your downside risk. Yet your upside earnings potential is unlimited. Aside from speculation, investors also use options for hedging purposes as a way to protect your portfolio from disaster. Hedging is like buying insurance — you buy it as a means of protection against unforeseen events, but you hope you never have to use it. The fact that you hold insurance helps you sleep better at night.

After you have decided whether you are hedging or speculating with your options purchase, you will then need to determine which specific options fit your needs. You will need to determine if your desired strategy requires you to trade a put or a call option, how long you wish the expiration date to be, and what strike price you would like to trade.

Another important thing to do before you begin is to familiarize yourself with the factors that impact options prices. That way, you’ll be able to choose the best trade to meet your needs.

Here is a brief overview of the factors that determine options pricing.

5 Factors That Determine Option Pricing

Option pricing is determined using a complex differential equation formulated by Myron Scholes and Fischer Black in 1973. In 1997, these two professors were awarded the Nobel Prize for their efforts. The Black-Scholes formula and its explanation are beyond the scope of this article. Fortunately, however, it is not necessary to understand the model’s intricacies in order to make proper option trades.

The five basic components of option pricing include the following:

1. Underlying Asset Price – The price of the underlying stock or index the option is written on.

2. Asset Volatility – Amount of uncertainty associated with the asset’s expected return. In general, the higher the volatility, the more expensive the option will be. For example, if an asset’s value is $100 today, and next month the price is estimated to be either $125 or $75, then the amount of uncertainty here is very high. Because of this, the option price will be high as well. After all, the more volatile the security, the greater chance that it will deliver large returns for the option holder. This uncertainty of return is one of the main drivers of option prices.

3. Time to Expiration – The amount of time left before the option expires. The price of an option decreases as it approaches its expiration date. Why is this? Well, as the expiration date approaches, the chances of the option gaining in value become lower and lower because the underlying security has less time in which to make a major up or down move.

4. Risk-Free Rate – For a variety of reasons that are beyond the scope of this report, the rate of return that may be earned without bearing any risk also comes into play when pricing options. Normally this is assumed to be the rate of interest earned by U.S. Treasury Bills.

5. Option Strike Price – This is the price at which the option can be exercised.

Bringing It All Together

All of these factors play an important role in determining every option’s price. The only two factors that an investor has any control over, however, are time to expiration and the strike price (this is assuming, of course, that you’ve already chosen the security on which you’re going to trade the option). Because of this, investors should concentrate their efforts on choosing the appropriate strike and expiration that best suits their needs.

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