Valuation of options

Option price components

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Interest rate Dividends and risk-free interest rate have a lesser effect. Changes in the underlying security price can increase or decrease the value of an option. These price changes have opposite effects on calls and puts.

For instance, as the value of the underlying security rises, a call will generally increase.

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However, the value of a put will generally decrease in price. A decrease in the underlying security's value generally has the opposite effect. The strike price determines whether an option has intrinsic value.

Understanding Option Pricing

An option's premium intrinsic value plus time value generally increases as the option becomes further in-the-money. It decreases as the option becomes more deeply out-of-the-money. Time option price components expiration, as discussed above, affects the time value component of an option's premium.

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Generally, as expiration approaches, the levels of an option's time value decrease or erode for both puts and calls. This effect is most noticeable with at-the-money options.

The effect of implied volatility is subjective and difficult to quantify.

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It can significantly affect the time value portion of an option's premium. Volatility is a measure of risk uncertaintyor variability of price of an option's underlying security.

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Higher volatility estimates indicate greater expected fluctuations in either direction in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike. It is most noticeable with at-the-money options.

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The effect of an underlying security's dividends and the current risk-free interest rate has a small but measurable effect on option premiums. This effect reflects the cost to carry shares in an underlying security.

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Cost of carry is the potential interest paid for margin or received from alternative investments such as a Treasury bill and the dividends from owning shares outright.