Options Education - The Fundamentals
Who sells options, and how are they priced?
In addition to buying options, it is also possible for both individuals and institutions to sell (write) options; however, much of the writing is done by institutions and professional investors rather than individual investors.
When it comes to option prices, the primary determinant of an option's price is the perceived likelihood of the option being exercised on or before its expiration date. Of course, there are numerous factors that influence this variable: the amount of time left on the option contract, the distance the stock is from the strike price, and the chance of the stock traveling that distance before the option expires are three of the big ones. In addition to these three primary forces, there is also a dose of supply-and-demand thrown into the mix, and thus option prices also tend to be influenced by the level of demand (or lack thereof) seen for them in the marketplace.
Of these factors, the passage of time is the only one that investors can predict with 100% certainty, and thus it plays one of the largest roles in determining option prices (options with more time left on them will have a higher price than options with similar strike prices but less time remaining). It is important for both sellers and buyers of options alike to realize that all options lose a portion of their value as time goes by, and this "time decay" accelerates as the option gets closer and closer to expiration.
Though a discussion of it is "beyond the scope of this course" (as some of my professors at Cal used to say in response to particularly difficult questions from students during class), investors who are interested learning more about how the pros value options are encouraged to investigate a nifty bit of mathematics called the Black-Scholes Equation.
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