What Determines an Option’s Price?
When you buy a stock, pricing is relatively straightforward because the value of your investment is directly attributable to the price of the stock itself. An option, conversely, is a derivative instrument whose value is, in part, based on the price of an underlying stock and, in part, on other factors. Analyzing option pricing can be a challenge because sometimes it is like trying to hit a moving target.
This chapter discusses option pricing from the perspective of establishing a position and changes in the option price after the position has been established. It covers the five factors that affect an option’s price and the basics of how to forecast a change in price. Chapter 4, “Tools of the Trade—Greeks,” provides further option pricing analysis.
Before you establish an option position, you should understand what causes one option to be priced higher or lower than the other. An option, in general, commands a higher premium under the following conditions:
• The lower the strike price of a call,
• The higher the strike price of a put,
• More time remaining until expiration,
• Greater implied volatility,
• Increase in the assumed interest rate for a call,
• Decrease in the assumed interest rate for a put,
• Decrease in the assumed dividend for a call,
• Increase in the assumed dividend for a put.
An option, in general, commands a lower premium under the following conditions:
• The higher the strike price of a call,
• The lower the ...