Options Trading System

Options fair value, open interest and expiration date

Options Fair Value

An option's fair value is simply a contract's value at the present moment. Depending on the market condition the fair value may fluctuate.

There are several parameters that affect a value and It is important to know them:

• A Valuation Date - the date for which you are evaluating fair value of an options (i.e., the current date);
• Expiration Date - the date when an option expires and after which it cannot be exercised;
• Stock Price - the price of an underlying stock at the time of its valuation;
• Strike Price - the price at which your option could be exercised;
• Volatility of Underlying Security - usually the annual standard deviation of an underlying security's price.
• Option's Type - Call or put.
• Style of Option - There are American style and European style options. American style options can be exercised at any time up to the expiration date. European style options may be exercised only on the expiration date itself.

Options Open Interest

The open interest is simply the number of open contracts - either puts or calls that are still opened and not closed and have not been exercised and have not expired yet. You have to understand that each open transaction has a buyer and a seller and when open interest is calculated it uses only one side of the contracts. You have to understand that open interest is not a trading volume. When you are selling short options it add to he open interest as you creating new options contracts. If you selling options you previously bought, the contracts just changing the hands and the open interest remains unchanged - there are no new contracts. When options are exercised, the open interest becomes lower as it reduces the number of contracts that are open. And, after expiration date open interest becomes zero as all contract has expired.

For better understanding we set the table below to show how open interest is calculated. Lets say we have  hypothetical options market where we have 5 traders and we mark those traders as from A to E

Options Expiration

Every 3rd Friday of the month is an expiration day on an options exchange, meaning that a number of options series expire on this day.

All those call options whose strike prices are higher than the price of the underlying stock or index will be worthless at the end of the expiration date. Those options series, on the other hand, whose strike prices are lower, will have some intrinsic value and may be exercised. The opposite applies, in the case of put options.

There are American style and European style options. Options which can be exercised at any time up to the expiration date are the American style options. Options which can only be exercised on the date itself, are the European style Options.

The options expiration date is the most important factor in calculating options prices:

• In order to price European style options, the Black Scholes model is used. The pricing is done by factoring in current stock prices, strike prices, time left until expiration, interest rates, any dividends, as well as the volatility of the underlying security.
• In order to price American style options the binomial model is used. The stock prices for various given time intervals within the expiration period, are calculated as a tree by the binomial model. The model determines how much a stock might increase or decrease in value by using the volatility of a stock and time left to expiration. All possible prices for a stock are calculated this way. Option prices are calculated using a risk neutral valuation , by working backwards from the expiration date to present. Fundamentally, each option is prices.