Up until now, we have vaguely mentioned that option premiums fluctuate with the movement in the underlying stock. However, it is much more complicated than that. In this lesson we will address the basics to how option premiums are valued.
There are six inputs that are used to determine the value of an option contract. They are:
- underlying stock price
- strike price
- time until expiration
- volatility
- dividend
- risk-free interest rate.
Underlying stock price
As the underlying stock prices rises or falls, the option premium will fluctuate with it. When the underlying stock price increases, call premiums tend to rise in value and put premiums tend to decrease. When the underlying stock price decreases, call premiums will tend to fall in value and put premiums will tend to rise.
Strike Price
As we talked about previously, the strike price is the price at which the option contract can be exercised. As the underlying stock of call options rise in value, the more premium will be demanded by call writers to take on the risk of assignment. The opposite would be true for put options.
Time until Expiration (Time Value)
The time value of an option represents the premium above and beyond its’ intrinsic value (in-the-money). An option that is out-of-the-money has only extrinsic (time) value. This topic was covered in lesson 1.6. The reason that OTM options have any value at all is because investors are willing to pay for an option contract that may have Intrinsic Value at expiration. Of course, this value decreases as the underlying stock price moves away from the strike price and/or the expiration date of the contract approaches.
That said, we can agree that as expiration approaches, OTM options will lose value as the likelihood of expiring ITM become less probable. This is known as Time Decay because time eats away at the value of the option contract. The longer the option has until expiration, the more the extrinsic value will typically be reflected in the option premium.
Implied Volatility (IV)
The volatility that is priced into an option contract is somewhat difficult to quantify. Implied Volatility (IV) represents the expected future price fluctuations of the underlying stock (usually based on 30 days out). Because this is a prediction of the future, it can sometimes be wrong. But we can generally say that the higher the IV, the more expensive the option premium. Why? Because the more an underlying stock is expected to fluctuate, the more risk sellers must be willing to take on. Hence, they will demand a higher premium.
If IV rises after an investor purchases a call or put option, the option premium can rise in value despite no movement in any of the other pricing input factors (including the underlying stock price). This topic will be further discussed in detail in future lessons.
Dividend
A stock price will drop by the amount of the dividend that is paid that day after it is issued. Therefore, the higher the cash dividend paid the more the call option will decrease in premium and the more the put option will increase in value the day after. This is a relatively minor factor in option pricing because dividends are not issued very often.
Risk-free Rate
The risk-free rate relates to the alternative investment in assets other than equity option contracts. The expected return for an option contract must be above the return an investor could incur if they purchased risk-free treasuries. This factor also has minimal effect on option pricing because interest rates do not fluctuate very often.
Future lessons will introduce more advanced topics on option premiums and pricing models. For now it is simply important to know the input factors into option pricing models.
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