How Is Option Priced?
Price of an option is critical and is a decisive factor to make money. A successful option trader considers those factors to make his trade to succeed.
Investor would analyse how the options are priced before buying or selling an option within a particular time period. Investor usually understands what factors would affect option’s price in selecting an option.
The value of option is determined by several factors relating to underlying stock and financial markets.
- Option Strike Price
Strike price determines if an option is In-The-Money, At-The-Money, and Out-Of-The-Money. The value of calls decline when the strike price increases while it increases as the strike price declines.
- Current Stock Price
Keeping all other factors unchanged, the price of a call option goes up and price of a put option goes down if price of the underlying stock is increased. It will be opposite when the price of stock decreases.
- Time remaining until expiration
Assuming other things remain unchanged, time value of both calls and puts decreases and decays to zero at expiration. Longer the time to expiration provides more value of underlying stock. The time value component of an option price erodes as expiration date approaches closer. Due to time decay effect, an Out-Of-The-Money option price will decrease over time and finally expires worthless. Hence we can say it is an enemy of option buyers while it is a friend to option sellers. If you have to make money in options trading in the long run, you should understand the impact of time on stock and option positions.
- Implied Volatility
There will be uncertainty associated with the returns on investment made in options trading. Volatility is a measure of risk / uncertainty of the underlying stock price of an option. The higher the variance in the stock price, the value of option will be higher as you would see there a possibility that the options will end in your favour profitably.
- Interest Rate
Opportunity cost comes into picture when the buyer pays price of the option at the time of buying. This cost depends upon the level of interest rates and the number of days remaining for expiration on the option. The impact of interest rate has something related with the “carrying cost” of stocks. When you think you are not bearish on a particular stock, it is good to buy a call option than stock itself as it requires less money.
Any change in the interest rate would affect the stock price. When it increases, the stock prices would fall as investors change their portfolio based on the risk levels. The value of a call automatically goes up and the value of a put comes down when there is an increase in interest rates.
Any payment of dividend during the period of an option contract would result in fall in the value of stock. Hence, higher the cash dividends paid on a stock, lower will be the call premium and higher will be the put premium.
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Dr. Harsimran Singh was awarded a Ph.D. by a California University for his research work in options trading strategies and he authored 12 books. He traded stock options for 35 years. At times, he traded over a $100 million in a month in his personal account. His research work in options trading has been filed for getting patented with The US Patent Office under Application # 61/999,957.