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.