Factors That Impact Option Prices

Factors That Impact Option Prices - Option Trading
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Factors Impacting Stock Options Prices
The main factors impacting the premium price of stock options are:
• The current stock price S0
• Strike price agreed on K
• Time to maturity/expiration T
• Volatility of the stock price 
• Risk-free interest rate r
• Dividends expected during option life
The Impact of Spot Prices on Option Prices
The price of the underlying is the key factor that determines the premium price of an option. The options payoff is the difference between the spot price and the strike price. The price of an option premium for a given strike price will change based on the price of the underlying stock.
Long call options are more valuable when the underlying spot price increases.
Long put options become more valuable when the underlying spot
price decreases.
Strike Price
The strike price is the contracted price that will be exchanged in the event of the exercise of the option by the option buyer. Hence strike price plays a vital role in determining the premium price of an option. The exercise price will remain the same throughout the life of an option contract and will not undergo any change, with the earlier-noted exceptions of relatively rare corporate actions such as special dividend announcements and stock splits.
Time to Maturity/Expiration
With more time, there is more uncertainty. The more time to expiration, the greater the chance that there will be fluctuation in the price of the underlying to the advantage of one of the parties to the contract. Thus, the greater the time, the higher the time value of the option. An option’s premium price is directly related to the time remaining till expiration. The buyer of an option stands to gain if the option contract finishes in the money. If there is more time to expiration, the chance of the option ending in the money is higher. As the time to expiration of an options contract passes, the value of the option erodes.
If an investor buys an option that is one year away from expiration, it will obviously be more expensive than a similar option that is only five minutes away from expiration. All options exhibit time decay and are wasting assets.
The Volatility of the Stock Price
The volatility of a stock price is a measure of how uncertain we are about future stock price movements. The standard deviation of the historical price movements of the underlying asset over a defined period of time is typically used to measure the volatility of that asset. The higher the volatility is, the more likely it is that an asset’s price will move up or down a lot. Thus, an option on a volatile asset is worth more than an option on an asset with little volatility. If a market becomes more volatile, the premium for option contracts, both puts and calls, would go up. Someone who bought options earlier would benefit if market volatility increases to the detriment of the person who sold the options to them.
Interest Rates
The cost of carry depends on 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.
Higher interest rates have two impacts on stock options valuations:
1. Higher expected return on stock
2. The present value of future cash flows of an option decrease
If all else is kept equal, an increase in interest rates increases call prices and decreases put prices.
Expected Dividends
Stock dividends are paid only to the holder of the underlying security on the record date. Owners of call options on the same underlying stock are not eligible to receive dividends. Dividends paid during the life of an options contract reduce the price of the underlying. This has to be reflected in the price of options.
An announcement of a new dividend or an increase in the dividend of an underlying stock reduces pre-existing market call prices and increases pre-existing market put prices. A surprise announcement of a reduction in a stock’s dividends has the effect of increasing pre-existing market call prices and decreasing pre-existing market put prices.

[@subhamdeshwal]

Amazing content. I have watched all your playlists. You’re a phenomenal teacher. I will be forwarding anyone I know that wants to learn about options to your videos. Thank you for uploading such important videos for free.

[@adequatequality]

Great video! Studying options Finance right now and this helped. Just one suggestion is to use graphics to make it a bit easier to remember what's being talked about. Cheers!

[@sarthakaneja101]

what about effect of cost of carry?

[@djayjp]

I understand you're referring to the Black-Scholes model, but the actual pricing, day to day, isn't that determined by the market and the sale prices of identical options? Therefore the actual price of an option may deviate substantially from this model, correct?

[@jacobdahl3653]

2:35 the reference to the if it expired tomorrow vs thirty years I think really drives the point home and it’s the first I’ve heard it that way and for me it took probing and losing money to figure that out 😂 🙃

[@PBoyle]

Thanks Jacob, Glad to have helped.

[@jacobdahl3653]

@@PBoyle absolutely and thank you I can’t tell you how much I appreciate the none scammers that share solid hard won knowledge

[@zachsmithers4378]

This was very helpful thank you!

[@PBoyle]

Thanks. Glad to help!

[@divyagupta5180]

That was very helpful Thank you

[@arfatulislam2526]

really helpful.thank you

[@PBoyle]

Thanks!

[@nicoleluo6692]

I guess the impact of expiration date/maturity on option price for European option is another thing

[@syeedmohammeduzzalhossain5452]

Wow.