Factors affecting the option premium
Email Email You can't know where you are going until you know where you've been. You can't price an option until autopilot options know what makes up its value. An options trade can become a complex machine of legs, multiple orders, adjustments, and Greeks, but if you don't know the fundamentals then what are you trying to accomplish?
When you look at an option chain have you ever wondered how they generated all those prices for the options? These options are not created by random but instead calculated out using a model such as the Black-Scholes Model.
We will dive deeper into the seven components of the Black-Scholes Model and how and why they are used to derive an option's price. Like all models, the Black-Scholes Model does have a weakness and is far from perfect.
An option premium is the current market price of an option contract. It is thus the income received by the seller writer of an option contract to another party. In-the-money option premiums are composed of two factors: intrinsic and extrinsic value.
It was developed by Fisher Black and Myron Scholes as a way to estimate the price of an option over time. Robert Merton later published a follow-up paper further expanding the understanding of the model.
Merton is credited for naming the model "Black-Scholes. Fisher Black was not eligible because the Nobel Prize cannot be awarded posthumously.
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.
As with any model, some assumptions have to be understood. The rate of return on the riskless asset is constant The underlying follows the more the option will be worth which states that move in a random and unpredictable path There is no arbitrage, riskless profit, opportunity It is possible to borrow and lend any amount of money at the riskless rate It is possible to buy or short any amount of stock There are no fees or cost There are seven factors in the model: stock price, strike price, type of option, time to expiration, interest rates, dividends and future volatility.
Factors affecting the option premium the seven factors, only one is not known with any certainty: future volatility. This is the main area where the model can skew the results.
The first fact is that when the strike exercise price for a contract is set at a higher level, the premium for the call option is lower and the premium for the put option is higher.
Stock Price If a call option allows you to buy a stock at a specified price in the future than the higher that price goes, the more the option will be worth. In this situation, our option value will be higher.
Strike Price Strike price follows along the same lines as stock price. When we classify strikes, we do it as in-the-money, at-the-money or out-of-the-money. When a call option is in-the-money, it means the stock price is higher than the strike price.
When a call is out-of-the-money, the stock price is less than the strike price. On the flip side of additional income earnings coin, a put option is in-the-money when the stock price is less than the strike price.
Factors Affecting the Prices of Option Premiums
A put option is out-of-the-money when the stock price is higher than the strike price. Options that are in-the-money have a higher value compared to options that are out-of-the-money.
Type Of Option This is probably the easiest factor to understand. An option is either a put or a call, and the value of the option will change accordingly.
Volatility and Time: Factors Affecting Option Premium
A call option gives the holder the right to buy the underlying at a specified price within a specific time period. A put option gives the holder the right to sell the underlying at a specified price within a specific time period. If you are long a call or short a put your option value increases as the market moves higher. If you are long a put or short a call your option value increases as the market moves lower.
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Time To Expiration Options have a limited lifespan thus their value is affected by the passing of time. As the time to expiration increases the value of the option increases.
As the time to expiration gets closer the value of the option begins to decrease. The value begins to rapidly decrease within the last thirty days of an option's life. The more time an option has till expiration, the more time the option has to move around.
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- Volatility and time are two important factors affecting option premium that stand out in evaluating the central question of value.
Interest Rates Interest rates have a minimal effect on an option's value. When interest rates rise a call option's value will also rise, and factors affecting the option premium put option's value will fall.
Plus we will have the same reward potential for half the risk. Now we can take that extra cash and invest it elsewhere such as Treasury Bills.
This would generate a guaranteed return on top of our investment in TOP. The higher the interest rate, the more attractive the second option becomes.