Options are used as risk management tools and the valuation or pricing of the instruments is a careful balance of market factors.
There are four major factors affecting the Option premium:
- Price of Underlying
- Time to Expiry
- Exercise Price Time to Maturity
- Volatility of the Underlying
And two less important factors:
- Short-Term Interest Rates
- Dividends
Review of Options Pricing Factors
The Intrinsic Value of an Option
The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.
For a call option: Intrinsic Value = Spot Price - Strike Price
For a put option: Intrinsic Value = Strike Price - Spot Price
The intrinsic value of an option must be positive or zero. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.
Price of underlying
The premium is affected by the price movements in the underlying
instrument. For Call options – the right to buy the underlying at a fixed strike
price – as the underlying price rises so does its premium. As the underlying price falls so does the cost of the option premium. For Put options – the right to sell the underlying at a fixed strike
price – as the underlying price rises, the premium falls; as the underlying price falls the premium cost rises.
The following chart summarises the above for Calls and Puts.
Option | Underlying price | Premium cost |
| Call |   | |
| Put | | |
The Time Value of an Option
Generally, the longer the time remaining until an option's expiration, the higher its premium will be. This is because the longer an option's lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an option's price remaining the same, the time value portion of an option's premium will decrease (or decay) with the passage of time.
Note: This time decay increases rapidly in the last several weeks of an option's life. When an option expires in-the-money, it is generally worth only its intrinsic value.
Option | Time to expiry | Premium cost |
| Call | | |
| Put | | |
Volatility
Volatility is the tendency of the underlying security's market price to fluctuate either up or down. It reflects a price change's magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an option's premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an under-lying stock increases, the premiums of both calls and puts overlying that stock increase, and vice versa.
Higher volatility=Higher premium
Lower volatility = Lower premium
Option | Volatility | Premium cost |
| Call | | |
| Put | | |
Interest rates
In general interest rates have the least influence on options and equate approximately to the cost of carry of a futures contract. If the size of the options contract is very large, then this factor may take on
some importance. All other factors being equal as interest rates rise, premium costs fall and vice versa. The relationship can be thought of as an opportunity cost. In order to buy an option, the buyer must either borrow funds or use funds on deposit. Either way the buyer incurs an interest rate cost. If interest rates are rising, then the opportunity cost of buying options increases and to compensate the buyer premium costs fall. Why should the buyer be compensated? Because the option writer receiving the premium can place the funds on deposit and receive more interest than was previously anticipated. The situation is reversed when interest rates fall – premiums rise. This time it is the writer who needs to be compensated.
Option | Interest rates | Premium cost |
| Call | | |
| Put |
| |
How do we measure the impact of change in each of these pricing determinants on option premium we shall learn in the next module.
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