Six primary factors influence option pricing: The most influential factor on an option premium is the current market price of the underlying asset. In general, as the price of the underlying increases, call prices increase and put prices decrease. Conversely, as the price of the underlying decreases, call prices decrease and put prices increase.
Remember, intrinsic value is the difference between the strike price of the option and the current price of the underlying. The premium typically increases as the option becomes further in-the-money where the strike price becomes more favorable in relation to the current underlying price. The premium generally decreases as the option becomes more out-of-the-money when the strike price is less favorable in relation to the underlying. The longer an option has until expiration, the greater the chance it will end up in-the-money , or profitable.
As expiration approaches, the option's time value decreases. As a general rule, an option loses one-third of its time value during the first half of its life, and two-thirds of its value during the second half. The underlying's volatility is a factor in time value: If the underlying is highly volatile, you can reasonably expect a greater degree of price movement before expiration.
The opposite holds true where the underlying exhibits low volatility: The time value will be lower if the underlying price is not expected to move much. It is a measure of the speed and magnitude of the underlying's price changes.
Implied volatility , on the other hand, is a forecast of future volatility and acts as an indicator of the current market sentiment. While implied volatility can be difficult to quantify, option premiums are generally higher if the underlying exhibits higher volatility, because it will have higher expected price fluctuations.
Interest rates and dividends have small, but measurable, effects on option prices. In general, as interest rates rise, call premiums increase and put premiums decrease.
This is because of the costs associated with owning the underlying: The purchase incurs either interest expense if the money is borrowed or lost interest income if existing funds are used to purchase the shares. In either case, the buyer will have interest costs. Dividends can affect option prices because the underlying stock's price typically drops by the amount of any cash dividend on the ex-dividend date. As a result, if the underlying's dividend increases, call prices will decrease and put prices will increase.
Conversely, if the underlying's dividend decreases, call prices will increase and put prices will decrease. Dictionary Term Of The Day. A conflict of interest inherent in any relationship where one party is expected to Broker Reviews Find the best broker for your trading or investing needs See Reviews. Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education.
A celebration of the most influential advisors and their contributions to critical conversations on finance. Become a day trader. Black-Scholes Model Options Pricing: The Greeks Options Pricing: Six factors that influence option pricing are shown on the top row of the chart.
As indicated, the underlying price and strike price determine the intrinsic value; the time until expiration and volatility determine the probability of a profitable move; the interest rates determine the cost of money; and dividends can cause an adjustment to share price. Underlying Price The most influential factor on an option premium is the current market price of the underlying asset.
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