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 inthemoney (where the strike price becomes more favorable in relation to the current underlying price). The premium generally decreases as the option becomes more outofthemoney (when the strike price is less favorable in relation to the underlying).
Premiums increase as options become further inthemoney 
Time Until Expiration
The longer an option has until expiration, the greater the chance that it will end up inthemoney, or profitable. As expiration approaches, the option's time value decreases. In general, an option loses onethird of its time value during the first half of its life and twothirds 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 exdividend 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 
RELATED TERMS

Derivative
A security with a price that is dependent upon or derived from ... 
Security
A financial instrument that represents an ownership position ... 
Series 6
A securities license entitling the holder to register as a limited ... 
Internal Rate Of Return  IRR
A metric used in capital budgeting measuring the profitability ... 
Board Of Directors  B Of D
A group of individuals that are elected as, or elected to act ... 
Strike Width
The difference between the strike price of an option and the ...
RELATED FAQS

How is the price of a derivative determined?
Many different types of derivatives have different pricing mechanisms. The most common derivative types are futures contracts, ... Read Full Answer >> 
What is a stock split? Why do stocks split?
All publiclytraded companies have a set number of shares that are outstanding on the stock market. A stock split is a decision ... Read Full Answer >> 
Is there a difference between financial spread betting and arbitrage?
Financial spread betting is a type of speculation that involves a highly leveraged derivative product, whereas arbitrage ... Read Full Answer >> 
How do I place an order to buy or sell shares?
It is easy to get started buying and selling stocks, especially with the advancements in online trading since the turn of ... Read Full Answer >> 
What does a high turnover ratio signify for an investment fund?
If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a oneyear period. ... Read Full Answer >> 
How does a forward contract differ from a call option?
Forward contracts and call options are different financial instruments that allow two parties to purchase or sell assets ... Read Full Answer >>