Options : What Affects Option Prices?
Option pricing is based on a variety of
factors. There are seven main components that affect the premium of an
option. These are:
- The current price of the underlying
financial instrument
- The strike price of the option in
comparison to the current market price (intrinsic value)
- The type of option (put or call)
- The amount of time remaining until
expiration (time value)
- The current risk-free interest rate
- The volatility of the underlying
financial instrument
- The dividend rate, if any, of the
underlying financial instrument
Each of these factors plays a unique
part in the price of an option. In most cases, the first 4 are pretty
easy to figure out. The rest are often forgotten or overlooked. However,
although they may be a little confusing, each is important. For example,
when it comes to trading with options, reviewing volatility levels can
help traders determine the right options strategy to employ.
In addition, it is noteworthy to assess the current risk-free interest
rate and whether or not a particular stock is prone to the release of
dividends. Higher interest rates can increase option premiums, while
lower interest rates can lead to a decrease in option premiums.
Dividends act in a similar way, increasing and decreasing an option
premium as they increase or decrease the price of the underlying asset.
Also, if a stock were to pay a dividend, a short seller would be
responsible for that payment. This means that a short seller in
securities not only has unlimited risk of the stock price rising, but
also is responsible for the dividends paid out.
Volatility -
This is one of the most important factors
in an option's price. It measures the amount by which an underlying
asset is expected to fluctuate in a given period of time. It
significantly impacts the price of an option's premium and heavily
contributes to an option's time value. In basic terms, volatility can be
viewed as the speed of change in the market, although you may prefer to
think of it as market confusion. The more confused a market is, the
better chance an option has of ending up in-the-money. A stable market
moves slowly. Volatility measures the speed of change in the price of
the underlying instrument or the option. The higher the volatility, the
more chance an option has of becoming profitable by expiration. That's
why volatility is a primary determinant in the valuation of options'
premiums. There are options strategies that can be used to take
advantage of either scenario.
Liquidity - Options strategies must be applied in specific market
conditions to be money-makers. Liquidity is one of these market
conditions. Liquidity is the ease with which a market can be traded. A
plentiful number of buyers and sellers boosts the volume of trading
producing a liquid market. Liquidity allows traders to get their orders
filled easily as well as to quickly exit a position.
The best way to discover which markets have liquidity is to actually
visit an exchange. The pits where you see absolute chaos are markets
with liquidity. As long as there are plenty of floor traders screaming
and yelling out orders as if their lives depended on it, you will
probably have no problem getting in and out of a trade. However, I tend
to avoid the pits where the floor traders are falling asleep as they
read the newspapers. These are obviously illiquid markets and it would
not be a wise move to place an options-based trade there.
If you don't have the ability to actually visit an exchange, you can
still check out the liquidity of a market by reviewing the market's
volume to see how many shares have been bought and sold in one day. As a
rule of thumb, I choose markets that trade at least 300,000 shares a
day, although one million shares a day is even better. It is also vital
to ascertain whether or not trading volume is increasing or decreasing.
This kind of volume movement is studied to indicate turning points in
market price action. You can also monitor liquidity by monitoring the
buying and selling of block trades-orders of 5,000 shares at a time-by
institutional traders.
Next-->> How to Read an Options
Table
Do not value money for any more nor any less than its worth;
it is a good
servant but a bad master.
-- Alexandre Dumas fils, Camille, 1852 --
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