BAJAJ BROKING
October 07, 2024
5 mins read
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.
Before you decide to place any options trade, you need to understand what truly impacts the price of an option contract. You may notice that option premiums often behave differently than the underlying stock or index. That is because there are multiple variables working together to influence an option’s price. These do not just include the asset’s market price, but also time, volatility, and interest rates, among others. If you are trying to plan your entry or exit, you must grasp how these factors interact and how each one may influence your trade outcome.
Below are the seven major factors that typically affect the price of an options contract:
You may already know this—the option’s price moves in relation to the price of the asset it is based on.
The premium of a call option generally increases when the underlying price rises, while put options may increase in value when the price falls. The stronger the move, the greater the impact on the premium, especially if the option becomes in-the-money.
The difference between the current asset price and the strike price affects the option’s intrinsic value.
The closer the strike price is to the asset’s current price, the more sensitive the premium becomes. Options that are deep in-the-money or out-of-the-money may have different risk-reward ratios and pricing behaviours.
As the option nears expiry, its time value reduces—a concept known as time decay or theta.
You might see this erosion accelerate in the last few days of the contract. Longer-dated options usually carry higher premiums, while shorter-dated ones decay faster, impacting how long you might want to hold your position.
If the market expects larger price swings, the option premiums tend to reflect that uncertainty.
Implied volatility increases the time value of options. Whether you hold a call or put, rising volatility can increase the premium. However, when volatility drops, you might notice the premium shrinking even if the price remains unchanged.
Even though this factor may seem minor, it can influence how options are priced—especially for longer expiries.
When interest rates rise, call option premiums may increase slightly due to the cost-of-carry concept. On the other hand, put options may slightly decrease in value, although the effect is more prominent in longer-dated contracts.
You should also account for any dividends expected on the underlying asset during the option's life.
If a company declares a dividend, the expected drop in stock price after the ex-dividend date may reduce the call option’s value and increase the value of puts. Traders often adjust their strategy based on such announcements.
Not all options behave the same—some are American-style and others are European-style, and that matters.
American options can be exercised before expiry, which adds flexibility and can influence pricing. European options, on the other hand, are exercisable only at maturity, which may reflect differently in their premium compared to American counterparts.
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.
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:
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.
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).
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.
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.
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.
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.
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.
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.
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Option prices are affected by multiple factors including the price of the underlying asset, time left to expiry, market volatility, interest rates, dividends, strike price, and the type of option contract. Each of these elements interacts to determine how the premium will be calculated at any given time.
The price of an option contract changes based on movements in the underlying asset, volatility expectations, time decay, interest rate shifts, and dividend declarations. You should also consider whether the option is in-the-money, at-the-money, or out-of-the-money when evaluating its value.
All of the following may affect an option's price: asset price movements, volatility changes, time to expiry, interest rate levels, dividends, the strike price, and whether the option is American or European. You need to watch how these factors play out to understand price shifts.
Disclaimer :
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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.
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