Option Pricing – The Factors Affecting Option Prices

Option Price involves two components – Intrinsic Value and Option Premium.Option Premium is the value we get by subtracting the Intrinsic Value of an Option from the Current Market Price of that particular Option.

Only In-the-Money Options have Intrinsic Value (explained below).Time Value of Option and Uncertainty in price of underlying security is reflected in Option Premium .There are several factors affecting Option Prices.Some are more significant while others have less significance for trading purposes.

If you take a look at an Option Calculator available in your Trading Account or Demat Account,You would find the following factors affecting the Option Prices (or Option Premium).

factors affecting option prices1. Volatility

2. Underlying Security Price

3. Option Strike Price

4. Dividend per annum

5. Interest Rate per annum

6. Duration Left in Contact Expiry or Time Value.

The other factor which holds prime significance in Option Pricing and we mentioned above is the Intrinsic Value.

Considering Dividend and Interest Rate constant,rest of these are the major factors affecting the Option Premium.

Then there are more mathematical factors,known as Option Greeks,which have effect on the Option Premium.These are Gamma,Vega,Delta,Rho.

Factors Affecting Option Prices

Volatility – Volatility measures the possible price fluctuations in a security.Rise in Volatility leads to rise in Option Premiums.Volatility is also correlated with Fear Factor.You would notice that before a big news announcement which may have a direct impact on that security,causes surge in Volatility.Consequently,Option Premiums also rise compared to non-eventful trading days.

Underlying Security Price – Change in market price of an underlying security has direct effect on Option Price.That is the main theme for playing with Options for speculative traders.When the market price of underlying security increases,the Call Options Premiums increase while the Put Options Premiums decrease.On the other hand,when security price decreases,the Put Options Premiums increase while the Call Options Premiums decrease.

Option Strike Price – Different Strike Prices for an Option show different response to change in market price of underlying security. Price change in Options prices is more for the Strikes which are near to current price of the underlying security.The Strike Prices far away from the current price of the security see comparatively small change.

Duration Left In Contract Expiry or Time Value – This is also an important factor you can not ignore.Each Option Contract has a fixed expiry date.With each passing day,the Option Premium keeps on decreasing,irrespective of the price changes in underlying security.This is called as Time Decay.Some novice traders fail to recognise the importance of Time Decay.Consequently,they suffer losses unknowingly.

Options Writers or Option Sellers use the Time Decay to their advantage.To take care of Time Decay,an Option Trader who wants to buy an Option should prefer Option Strikes which are near the current price of the security.

Dividend and Interest Rate – They don’t hold much significance for trading purposes.They indicate the interest rate incurred on the cost of carrying the entire trade value and the Dividend yield on it.

Intrinsic Value – This is the inherent value of an Option.For a particular Option to have an Intrinsic Value,it is compulsory that the current market price of the underlying security has crossed that Option Strike.

These Options are called as In-The-Money Options.The Option with Strike Price near to the security price is known as At-the-Money Option.The far away Strike Price is known as Out-Of-Money Option.

Suppose a stock is trading currently at ₹ 1000.All Call Options with Strike Price below 1000 shall be In-The-Money.A 980 Strike Call Option shall have an Intrinsic Value of 20 (Strike of 1020 would be At-the-Money while 1040 or higher are Out-of-Money).

For a Put Option,all the Put Options with Strike Price above 1000 shall be In-The-Money Options.Here a Put Option with 1020 Strike Price shall have Intrinsic Value of 20 (Strike of 980 would be At-the-Money while 960 and lower are Out-of-Money).

Let us say,the price of 980 Strike Call Option for the above stock is ₹ 28 with stock price ₹ 1000.The price split for this Option would be 1000-980=20 (Intrinsic Value) + 8 (Premium) = 28.Lower the Premium,the cheaper the Option is to buy.

At the time of expiry of Options Contract,what is left in an Option is only its Intrinsic Value ( Last traded price of the security – Strike Price = Intrinsic Value).

The value of all Out-of-Money Option Strikes, above the last traded price for Call Options and below the last traded price for the Put Options, of the underlying security at the time of expiry turn to Zero ( Remember,In-the-Money Options retain their Intrinsic Value even at expiry).

Continue to next page to know about the Greeks which affect the option pricing.

Get more stuff like this
in your inbox

Subscribe to our mailing list and get interesting stuff and updates to your email inbox.

Thank you for subscribing.

Something went wrong.