The current price of the underlying is obviously a very important factor that determines the price of an Option. Also the strike price of the contract is another key factor that affects the price of an Option. The time to expiry is again another important factor that affects the price of an Option. The intrinsic value of an option represents the amount of an option that is in-the-money (ITM). Note that OTM and ATM options have no intrinsic value. In short all the ‘Greeks’ affect the pricing of an option contract as described elaborately later in this chapter.
The price of the underlying is the key factor that determines the price of an option. The price of an option premium for a given strike price will undergo change based on the price of the underlying stock. The closer the market price is to the strike price, the rate of change will be the highest. For strike prices farther away from the market price, the rate of change of option premium will be lower.
Strike price is the contracted price that would be exchanged in the event of the exercise of the option by the buyer of the contract. Hence strike price plays a vital role in determining the price of an option contract. The exercise price will remain the same throughout the life of an option contract and will not undergo any change. However, in the case of a stock split there would be change in the strike price.
With more time there is more uncertainty. More the time to expiry, greater are the chances that there would be fluctuation in the price of the underlying to the advantage of one of the parties to the contract. Hence more the time, higher would be the time value of the premium. The option’s price is directly related to the time remaining till the expiration of the option contract. The buyer of an option stands to gain if the option contract finishes in-the-money – and greater are the chances that it would do so if there is more time to expiry. It should be noted that as the time to expiration of the option contract decreases, the value of the option would erode.
If an investor buys an option that is three months away from expiration, it will be more expensive than a similar option that is only five days from expiration. All options exhibit time decay and are wasting assets. In other words, as time passes, option contracts lose value. If the investor buys an option that is three months away from expiration and hold it until there are only five days until expiration, there will be a significant premium loss due to time depreciation assuming the price of the underlying is more or less constant.
The cost of carry would depend upon the risk-free rate of interest in the market concerned. The higher the interest rate, the higher the call option price and lower the put option price. The lower the interest rate, the lower the call option price and higher the put option price.
Volatility is the standard deviation of the price of the underlying over a defined period of time. If a market becomes more volatile, the premium for option contracts would go up. Someone who bought options earlier would be benefited to the detriment of someone who previously sold options. Buying options prior to such volatility expansion has a high probability of success. Higher the volatility more would be the premium of options.
Dividends or expected dividends of an underlying stock impacts in a peculiar way the pricing of its derivative be it futures or options. The reason being that once the underlying goes ex-dividend, the market rate of the underlying gets reduced exactly by the amount of dividend declared per share. As a result of this the future market rate of the underlying should be discounted to the extent of the dividend per share.
To understand fully the impact of dividends on the option pricing, you should know that dividends are paid only to the holder of the underlying on the record date. The holders of call options on the same underlying stock however are not eligible to get any dividends. Hence, when dividend is declared by the company, the holders of the underlying stock are benefited to the extent of the dividend declared, while the holders of the call option are deprived of the same. This is reflected in the price of the call option.
Similarly, short sellers of an underlying stock that carries a dividend component are required to pay the dividend to the owner from whom they borrowed the stock which offsets the interest they receive for the short position they hold. This has the effect of increasing the price of a put option whenever dividend is declared on the underlying stock.
In short, an increase in the dividend of the underlying stock has the effect of reducing the call prices and increasing the put prices. A reduction in the dividend has the effect of increasing the call prices and decreasing the put prices.