Equity and Index Options Explained

9

Option Pricing Revisited; the “Greeks”

Chapter 7 focused upon the various factors that influence the price of an option. Generically, option prices are influenced by four variables:

1. Underlying price in relation to the option strike price
2. Time to expiry
3. Interest rates
4. Volatility

Single stock options may also be affected by a fifth factor, dividends.

Whether we are trying to roughly price an option using our intuition or value more accurately with a pricing model, it is the four (or five) factors listed above that are key. Let's reconsider the relationships between each of these four main factors and option prices.

1. Underlying Price

All other things being equal, as the underlying rises, call prices rise and put prices fall.

All other things being equal, as the underlying falls, put prices rise and call prices fall.

2. Time

All other things being equal, the passage of time causes option prices to fall. This process is known as “time decay” or “erosion”.

3. Interest Rates

Interest rates may affect options in two ways, depending upon their exact nature.

1. In relation to physically deliverable stock options (other things being equal):

   As interest rates rise, the value of calls rise and put prices fall.

   As interest rates fall, the value of puts rise and call prices fall.

2. In relation to all options (other things being equal):

   As interest rates rise, the value of all options (calls and puts) falls.

   As interest rates fall, the value of all options (calls and puts) rises.

4. Volatility ...