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7 Factors Affecting Option Price

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Synopsis:

Options are derivative contracts that are widely popular across the globe. In this article, we shall discuss the prominent factors affecting option prices, ranging from strike price to volatility.

The derivatives market is a fascinating facet of the securities market, and instruments such as futures and options add another dimension to trading. Options trading is a complex and dynamic discipline that requires an acute understanding of various elements, including option prices, option premium, and the patterns of market movements. 

In this article, we shall discuss 

  • What is an option 

  • Which factors determine the price of an option contract 

What is an options contract? 

An option is a derivatives contract that entails the option (but not the obligation) to buy or sell a financial asset or a commodity at a pre-decided price until a predetermined date in the future. With options trading, traders strive to navigate the myriad of turns in the market and mitigate future risks whilst benefiting from potential gains. As opposed to a futures contract, an options contract does not result in a buy or sell obligation. As such, options are considered highly dynamic derivatives. 

There are two types of options contracts, namely a call option and a put option. While a call option confers upon the holder the right but not the obligation to buy a financial asset or commodity at an agreed upon price till a specific time in the future, a put option confers upon the holder a corresponding right to sell said asset/ commodity. Both types of options find widespread application in modern-day stock trading. 

Major factors affecting option prices

Options trading strategies are as diverse and complex as the underlying instruments. As such, it is critical to understand which options contract to go for at a particular point in time, how to determine option price, whether to exercise an option and, if so, at what time in the tenure of the instrument, etc. 

Option pricing is a discipline that entails the usage of several widely popular yet not entirely accurate mathematical formulae. You can either use one such formula, for instance, the Black Scholes formula. Alternatively, you can gain an understanding of the key factors that affect option prices, which are as follows:

  1. Price of the underlying asset:  Since options trading is essentially centered around the potential price movements of an underlying security, for instance, the stock of a particular company, the underlying price is an integral factor affecting option prices and the type of option to purchase. If the price of the underlying security is expected to rise, a call option may be a reasonable choice; conversely, a put option may be preferable if the price is expected to decline.

  2. Strike price:  Another key factor affecting option price is the strike price, that is, the price at which the option is agreed to be exercised. For example, if A buys a call option for 50 shares of company X at a strike price of Rs. 500 per share, A can exercise the option to buy the shares at Rs. 500 any time before the option expires. Should the market price of company X’s shares rise above Rs. 500 at any time during the tenure of the option, A is in a position to exercise the call option and purchase the shares at the strike price of Rs. 500, thereby earning a profit (difference between the market price and the strike price).

  3. Time to expiration:  The time for which an option stays live plays an instrumental role in options pricing. Owing to the concept of time decay, an option declines in value as the date of expiration approaches. Therefore, should there be no significant movement in the market price of the underlying security during the majority of an options tenure, the holder shall be less inclined to exercise it (since there is no profit to be made or risk to be mitigated). Since time is a complex concept, its application in option pricing is constantly evolving. 

  4. Shifts in interest rates:  The direction and magnitude of interest rate changes is another pivotal factor affecting option prices. Changes in interest rates can affect the profitability of options contracts by influencing the cost of holding or shorting the underlying assets. Furthermore, the impact of interest rate changes on different types of options contracts also varies. 

  5. Type of options contract:  Another key variable affecting option price is the type of the options contract. Various types of options contracts are priced differently in varying market scenarios. If the market is bullish, then call options tend to be priced at a premium (with the expectation of a further rise in security prices) and put options register a decline in prices and premium. In stark contrast, bearish markets entail a high price and premium for put options (with the expectation of a further fall in security prices) and a corresponding low price for call options. 

  6. Future volatility:  Of all the factors affecting option prices, volatility is, arguably, the most dynamic. Since there is no certain way to predict the precise degree of the price movement for any particular asset, there is no precise quantum of future volatility that can be entered into an option pricing formula to determine the right price. The expected future volatility, or implied volatility, in the market is a crucial factor affecting option premium. 

  7. Dividend:  Dividends are a key external factor affecting option prices. The timing and amount of dividend payments can significantly influence the pricing of options on dividend-paying stocks. Not only do dividend payouts affect the actual return on any stock, but they also have a substantial impact on the public perception about the pertinent company. Deciding the appropriate strike price for an options contract in line with dividend announcements for the underlying shares is another integral aspect of options pricing and options trading strategies. 

The bottomline 

It is important to understand the various variables that affect option prices as well as the way such impact transpires. Once you understand how options are priced, you can be well placed to decide whether an option is worth choosing. 

Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing.

This content is for educational purposes only. Securities quoted are exemplary and not recommendatory.

For All Disclaimers Click Here: https://bit.ly/3Tcsfuc

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