Options Pricing: Factors That Influence Option Price

There are six primary factors that influence option prices, as shown in Figure 2 and discussed below.

Figure 2: Six factors that affect option prices are shown on the top row. As indicated, the underlying price and strike price determine the intrinsic value; the time until expiration and volatility determine the probability of a profitable move; the interest rates determine the cost of money; and dividends can cause an adjustment to share price.

Underlying Price
The most influential factor on an option premium is the current market price of the underlying asset. In general, as the price of the underlying increases, call prices increase and put prices decrease. Conversely, as the price of the underlying decreases, call prices decrease and put prices increase.

If underlying prices ...	Call prices will ...	Put prices will ...
Increase	Increase	Decrease
Decrease	Decrease	Increase

Expected Volatility
Volatility is the degree to which price moves, regardless of direction. It is a measure of the speed and magnitude of the underlying's price changes. Historical volatility refers to the actual price changes that have been observed over a specified time period. Option traders can evaluate historical volatility to determine possible volatility in the future. Implied volatility, on the other hand, is a forecast of future volatility and acts as an indicator of the current market sentiment. While implied volatility is often difficult to quantify, option premiums will generally be higher if the underlying exhibits higher volatility, because it will have higher expected price fluctuations.

The greater the expected volatility, the higher the option value

Strike Price
The strike price determines if the option has any intrinsic value. Remember, intrinsic value is the difference between the strike price of the option and the current price of the underlying. The premium typically increases as the option becomes further in-the-money (where the strike price becomes more favorable in relation to the current underlying price). The premium generally decreases as the option becomes more out-of-the-money (when the strike price is less favorable in relation to the underlying).

Premiums increase as options become further in-the-money

Time Until Expiration
The longer an option has until expiration, the greater the chance that it will end up in-the-money, or profitable. As expiration approaches, the option's time value decreases. In general, an option loses one-third of its time value during the first half of its life and two-thirds of its value during the second half. The underlying's volatility is a factor in time value; if the underlying is highly volatile, one could reasonably expect a greater degree of price movement before expiration. The opposite holds true where the underlying typically exhibits low volatility; the time value will be lower if the underlying price is not expected to move much.

The longer the time until expiration, the higher the option price

The shorter the time until expiration, the lower the option price

Interest Rate and Dividends
Interest rates and dividends also have small, but measurable, effects on option prices. In general, as interest rates rise, call premiums will increase and put premiums will decrease. This is because of the costs associated with owning the underlying; the purchase will incur either interest expense (if the money is borrowed) or lost interest income (if existing funds are used to purchase the shares). In either case, the buyer will have interest costs.

If interest rates ...	Call prices will ...	Put prices will ...
Rise	Increase	Decrease
Fall	Decrease	Increase

Dividends can affect option prices because the underlying stock's price typically drops by the amount of any cash dividend on the ex-dividend date. As a result, if the underlying's dividend increases, call prices will decrease and put prices will increase. Conversely, if the underlying's dividend decreases, call prices will increase and put prices will decrease.

If dividends ...	Call prices will ...	Put prices will ...
Rise	Decrease	Increase
Fall	Increase	Decrease