Underlying Price and How It Affects Option Values

This page explains option underlying price (the price of the option's underlying asset), how it relates to strike price, and how it affects call and put option values.

What Is Underlying Price

Underlying price of an option is the current market price of the option's underlying asset.

Every option has an underlying asset (or underlying security or just underlying). A call option represents a right to buy the underlying asset at a fixed price (the option's strike price). A put option is a right to sell the underlying asset.

Example

For instance, the underlying asset for a 200-strike Apple call option is the Apple stock. This option represents the right to buy 100 shares of Apple at the fixed strike price of $200 per share.

Note: Stock options traded on US exchanges typically have a contract multiplier of 100, which means one option contract is for 100 shares of the underlying stock.

Underlying price for this option is the current share price of Apple in the stock market.

Underlying Price vs. Strike Price

Every option has a strike price and an underlying price. It is very important to understand their difference.

Strike price is fixed. It is one of the parameters (specifications) of the particular option contract. It is the price at which the option holder can buy (if it is a call option) or sell (if put) the underlying security when exercising the option (an alternative name for strike price is exercise price).

Underlying price is variable. It is not specific to the option contract. Instead, it is specific to its underlying asset and it constantly changes. It is the price at which anyone (not just the option holder) can buy or sell the underlying asset directly in the stock market (if the underlying is a stock).

Option as an Alternative

There are two alternative ways to buy the underlying asset: either by exercising a call option or directly in the stock market.

Strike price and underlying price are the prices of each of these two alternatives.

Depending on the relationship between strike price and underlying price, one of these two alternatives is more attractive than the other.

The "better" the (fixed) strike price is relative to the (variable) underlying price, the more attractive it is to use the option (exercise it) rather than buy the underlying asset directly, and the more valuable the option is.

How Underlying Price Affects Call Option Values

Underlying Price above Strike Price

For instance, if the Apple share price is currently 230 in the stock market, a 200-strike Apple call option, which represents the right to buy 100 shares of Apple for $200 per share, is very valuable, as it allows the option holder to save $30 on each of 100 shares he can buy with the option. This option will certainly be trading at high premium in the options market.

The saving of $30 per share can be calculated as the difference between underlying price ($230) and strike price ($200). It is called the option's intrinsic value and it is one of the two components of option premium (the other component is time value).

Underlying Price below Strike Price

Now consider an alternative scenario with Apple stock price at only 180. This means anyone can buy shares in Apple (the underlying asset) for $180 per share in the stock market. The option to buy them for $200 per share is not that attractive now. It won't save the option holder any money, so he will choose to not exercise the option and will buy the shares for $180 in the stock market instead. There is no saving with the option now – its intrinsic value is zero and the option is out of the money.

With underlying price at 180, the 200-strike call option will be worth much less than with underlying price at 230. It may not be worth zero, because there is still time value – a possibility that underlying price will rise above 200 before the option expires, allowing the holder to exercise later. Nonetheless, at underlying price 180, the option premium is much lower than at 230.

In general, the higher underlying price, the more valuable a call option is.

Underlying Price and Put Option Values

The relationship is the opposite with put options. Because they represent a right to sell (not buy) the underlying asset at the strike price, put options are more valuable when underlying price is low.

When underlying price is below a put option's strike price, the option holder can exercise the option to sell the underlying asset more expensively (for the fixed strike price) and get more cash than he would otherwise have received from selling the underlying directly in the stock market (for the underlying price).

Summary

Changes in underlying price have significant effect on option prices.

This effect is opposite for calls and puts.

The higher underlying price (relative to the fixed strike price), the higher call option values and the lower put option values.

Note: The relationship between underlying price and option price is not linear (due to the effects of volatility and time).

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