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

Catastrophe Equity Put (CatEPut)
Catastrophe equity puts are used to ensure that insurance companies ... 
Open Trade Equity (OTE)
Open trade equity (OTE) is the equity in an open futures contract. 
Bid Wanted
An announcement by an investor who holds a security that he or ... 
Multibank Holding Company
A company that owns or controls two or more banks. Mutlibank ... 
Short Put
A type of strategy regarding a put option, which is a contract ... 
Wingspread
To maximize potential returns for certain levels of risk (while ...

What options strategies are best suited for investing in the aerospace sector?
Learn how investors profit from volatility in the aerospace sector by employing options strategies, which include the long ... 
What options strategies are best suited for investing in the Internet sector?
Learn how two popular options strategies, the long straddle and the long strangle, enable investors to make money on the ... 
How many attempts at the Series 7 exam are permitted?
The National Association of Securities Dealers (NASD) has not placed any limits on the number of times you can attempt to ... 
Where can I buy covered call ETFs (exchangetraded funds)?
Learn where to trade covered call option strategies, and how covered calls work including the type of risk associated with ...