Factors Determining Options Pricing

Factors Determining Options Pricing

confused

Hello mathew here .!!
I wonder why my call option’s premium is falling even when the stock price is rising ??? Could you please suggest me on that.. ???

 At times you may face a situation when you see that the stock price is going up/down but the call/put option’s premium that you have purchased is falling or staying at the same level. And you wonder why markets are so irrational ??

If you face the same, then you are on the right blog !! 

 

There are Six factors that governs the price of an option, and are as follows:
1. The current Stock Price
2. The Strike Price
3. The Time to expiration
4. The Implied volatility of the stock price
5. The Risk free interest rate
6. The dividend expected during the life of the Option.

Let’s unfold them one by one….

1. The current Stock Price:

  • The option premium keeps fluctuating with the price of the underlying stock
  • The rate of change will be the highest for the strike price closer to the spot price
  • For strike prices far from the market price , the rate of change of option premium will be lower
  • But at times don’t be shocked if you see the price of the underlying is increasing but the price of your call is decreasing, because there are other factors too which are as follows:

strike of the option Nifty

2. The Strike Price:

  • It is the price at which a call owner may purchase stock, and the put owner may sell stock.
  • In the case of a stock split there would be change in the strike price
  • Calls become more expensive as the strike price moves lower
  • Also Puts becomes more expensive in value as the strike price increases
  • Also an Option’s premium (intrinsic value plus time value) decreases as the Option becomes more deeply out of the money
  • The strike price determines whether or not as Option has any intrinsic value

3. The time to expiration:

  • The longer the time to expiration date, the more valuable the Call/Put options
  • It is because there is greater the probability call/put option to turn from OTM to ITM
  • Time factor can decrease option value at a faster rate as it gets closer to expiration

Option-Theta-Time-Decay

Also Read : Alpha, the God of Active Investments!

4. The Implied Volatility of the stock price:

  • Volatility is a measure of how rapidly and how widely a stock price swings up and down
  • An option of a volatile stock is much more expensive than one of a less volatile stock
  • Remember a small change in the volatility estimate can have a big impact on an option’s price

5. The Risk free interest rate:

  • When interest rates are on the rise , the value of call options rise and the value of puts will fall
  • Say Interest rate hikes, perhaps 20%
  • You have $100,000 in the money-market that you would like to invest in stocks
  • You can either buy the stocks today or for a fee buy a call option which gives you control of the stock but allows you to defer payment
  • So you buy the call option and hang on to your money and continue to earn interest
  • Investors in the market follow this same line of reasoning and bid the calls higher as interest rates rise
  • Puts give you the right to sell your stock, which represents a cash flow into the account at a later date
  • So you sell the puts to generate cash into the account so it can earn the high rate of interest. The lack of put buyers (or the increase of put sellers) causes the price of puts to fall
  • This being a small factor but still is very vital for an option’s premium

6. The dividend expected during the life of the option:

  • Stock dividends also have little effect on option prices
  • Call prices fall and put prices rise with all other factors remaining same
  • It is because the price of the stock is reduced by the amount of the dividend for the next trading session

Also Read : Are you synced in to the Market?

To sum up, let’s look at the below table, which shows how an increase in the above mentioned factors can lead to change in the price of the call and put option.

Summary

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