The Factors Impacting Option Prices
Options are a type of derivative security that gives the holder the right, but not the obligation, to buy or sell an underlying at a predetermined price on or before the expiration date. Options trading can be profitable, but at the same time it can be risky too. To make successful trades, it is important to understand the various factors that determine the price of an option.
Stock Prices
The most important aspect that affects the price of an option is the price of the underlying stock. Stock prices play the biggest role in determining option values because the option premium is derived from the current market price of the stock. The stock price affects the option premium in two ways-for a call option, a higher stock price increases the option premium and for a put option a higher stock price decreases the option premium.
Volatility
The volatility is another important factor that affects option prices. Volatility is an indication of the possible price range of a security over an expected period and it is usually expressed as a percentage. Generally, a higher volatility results in a higher option premium and a lower volatility leads to a lower option premium.
Time Value
The time value of an option is another factor that determines the option premium. Every option has an expiration date and with the passage of time, the option gradually loses its value. This is known as the time value of an option and it is the difference between the option premium and the intrinsic value of the option.
Interest Rates
The interest rate is also another factor that affects the option premium of an option. Generally, higher interest rates have an upward pressure on call option premiums, while lower interest rates have a downward pressure on call option premiums. Similarly, higher interest rates have a downward pressure on put option premiums, while lower interest rates have an upward pressure on put option premiums.
Strike Price
The strike price is the price at which the underlying asset must be bought or sold if the option is exercised. The option premiums also depend on the strike prices, as it affects the intrinsic value of the option. A higher strike price or higher exercise price results in a lower option premium and a lower strike price or lower exercise price leads to a higher option premium.
Expiration Date
The expiration date of an option is the date when the option expires and becomes invalid. The option premium and the time value of the option are inversely related, which means that as the expiration date nears the time value of the option gradually decreases and so does the option premium.
Implied Volatility
Implied volatility is the expected level of volatility of the underlying stock in the future. It is calculated using the current market price of the option, strike price, time to the expiration date, risk-free rate and the current stock price. Generally, a higher implied volatility results in a higher option premium and a lower implied volatility leads to a lower option premium.
Option Premium
Option premiums are the prices at which two parties agree to buy or sell an option. It is important to remember that the option premium is not the same as the intrinsic value of an option; the option premium is the price at which the two parties agree to buy or sell an option and the intrinsic value is the amount of money that an option holder will realize if he exercises the option.
Dividends
Dividends are periodic payments made by a company to its shareholders out of its profits. The impact of dividends on option premiums depends on the type of option; for a call option dividends have a downward pressure on the option premium, while for a put option dividends have an upward pressure on the option premium.
Mutual Funds
Mutual funds are investment pools that allow investors to buy shares in a professionally managed portfolio of stocks, bonds, or other assets. The effect of mutual funds on option prices depends on the specific mutual fund, as some are more volatile than others.
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