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LearningFACTORS INFLUENCING OPTION PREMIUM/BASIC OPTION PRICING INGREDIENTS

PUTSUNDERSTANDING VOLATILITY

Darren Krett

Friday, 10 February 2023

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FACTORS INFLUENCING OPTION PREMIUM/BASIC OPTION PRICING INGREDIENTS-image

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FACTORS INFLUENCING OPTION PREMIUM/BASIC OPTION PRICING INGREDIENTS

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The following are the most common inputs to any options pricing model and are the most important factors influencing the options total premium.

  1. Exercise price-a benchmark for an option's intrinsic value, it is also known as the strike price of the option. As mentioned above, the exercise price is the price at which you will either take delivery of (in the case of a call) or make delivery of (in the case of a put) the underlying security. The exercise price of the option itself never changes throughout its life.

  2. The current price of the underlying security the other half of what's needed to determine an option's intrinsic value. The difference between the price of the underlying and the option exercise price will determine the amount of intrinsic value (parity) that an option carries in it. underlying price is above the strike price, the call option at that strike carries the intrinsic value. If the underlying price is below the strike price, the put at that strike is the option that carries intrinsic value. Only one option per strike (either call or put) will carry intrinsic value.

  3. Time to maturity-an option loses time value as it approaches maturity-it is a wasting asset. The amount of time that an option has until expiration greatly impacts the value of that option.

  4. Volatility-the higher the volatility, the higher the option premium. Reason: there is a greater chance for the option to become profitable, so traders are willing to pay more for it. Another way to think of it is that the greater the level of volatility, the greater the risk that the seller is taking when she sells or 'writes' that option, so she must charge more for it. This is the only truly unknown factor when pricing an option.

  5. The short-term interest rate the cost of money will be taken into account in the pricing of an option, since the buying or selling of options will result in a cash flow either in or out of an account. Interest rates may affect the forward price of the underlying contract as in equities (minus any dividends), or they may affect the carrying costs of the option itself.

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PUTSUNDERSTANDING VOLATILITY

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