Options Pricing: Factors That Influence Option Price

Six primary factors influence options pricing: the underlying price, strike price, time until expiration, volatility, interest rates and dividends. 
 

Figure 2: 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. 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.

Strike Price

The strike price determines if the option has any intrinsic value. Remember, intrinsic value is the difference between the strike price of the option and the current price of the underlying asset. 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 security).

Time Until Expiration

The longer an option has until expiration, the greater the chance it will end up in-the-money (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 asset'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.

Expected Volatility

Volatility is the degree to which price moves, whether it goes up or down. It is a measure of the speed and magnitude of the underlying's price changes. Historical volatility refers to the actual price changes that have been observed over a specified time period. Options traders can evaluate historical volatility to determine possible volatility in the future. 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  

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

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.