7.10

LEAPS® Pricing

Options pricing models use five factors to determine an option's theoretical value:

  • Stock or ETF price
  • Strike price
  • Time to expiration
  • Interest rates (minus dividends)
  • Volatility of the underlying stock

For shorter-term options, it is common to use an interest rate that approximates the risk-free interest rate. Most people use the U.S. Treasury-bill rate (90-day).

Pricing longer-term options is more difficult than pricing shorter-term options. To price a LEAPS® option, it is necessary to predict volatility (expectation of price fluctuation) of the underlying stock and interest rates for up to 2-½ years. Of the factors mentioned, interest rates play a more significant role in the pricing of longer-dated options due to the length of time. As a result, even professionals struggle to quote prices for options with maturity dates far in the future. The predictability of the inputs is more unreliable than for shorter-term options. Changes in implied volatility can also significantly alter LEAPS® options’ premiums.

Despite difficulties, exchange policies generally require market makers and specialists to offer quotations (both bid and offer) for up to 10 contracts. This allows investors to find a market for LEAPS® at any time.

 

Sponsored By:

  • OCC

OIC Participant Exchanges:

  • BOX
  • Cboe
  • MIAX
  • Nasdaq
  • NYSE

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