Option Pricing: What You Don’t Know Could Affect Your Premium

Have you ever heard the saying, “What you don’t know can’t hurt you?” While this may be true for many things, it isn’t with option pricing. There are several factors that can, and will, influence your premium. Knowing what these factors are and understanding how they affect your option pricing can help you determine the value of an option premium as it changes within the market.

What is an Option Premium?

Before we discuss the five factors that influence your option premium, let’s take a moment to determine exactly what an option premium is. An option premium is the amount an individual pays for an option, prior to sharing. When purchased, an individual has the right to certain options: either to call (buy) or put (sell) a security at a specific price. The option premium is the full payment for the option, not a down payment, so once it is purchased the buyer holds all the rights to that specific contract, whether the option is exercised or not.

There are two main components of an option premium you should understand. The first refers to calls and puts and is known as the intrinsic value of the option. The second is the time value of the premium. This is any amount an individual is willing to pay for an option that exceeds the intrinsic value. This excess is generally used by an investor in hopes that the value of the option will increase because the underlying security’s price has increased due to changes in market conditions.

Five Factors That Influence Your Option Premiums

  • Security Price- The overall price of the security can greatly affect the value of your option premium, either increasing it or decreasing it. Whatever change occurs in this price will affect the puts and calls for your option differently. For instance, if a change in market causes the underlying security’s value to rise, a call will usually increase in value while a put decreases.
  • Strike Price- The strike price, or the price at which the call or put can be exercised by the investor, can determine how much intrinsic value an option has. If there is excess premium, also known as time value, the option is said to be ‘in the money.’ If not, the option is ‘out of the money.’
  • Time- Each option has an expiration, and the time is it allowed to be influenced by the market can greatly affect its premium. Also, as the option’s expiration date draws closer, its value will usually erode.
  • Volatility- The volatility of premium, or the risk the underlying security faces, can affect both the price of the security and the value of the option. The more risk the option faces in option trading, the great fluctuation to the price.
  • Dividends and Interest Rates- While the effects of dividends and interest rates may be small, they still make a measurable impact on your option premium. These two reflect the amount of money is costs to carry the options of a security. In other words, the interest that must be paid or received for investment and the amount of money that owning shares will receive.

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