Factors affecting Option Premium
In our earlier units, there were several points where we discussed Option Premium. It is basically the current market price of an option contract. Here in this section, we will learn the factors that affect the options premium.
Let us understand these factors with the help of an analogy. Yesterday I was watching a Bollywood Thriller movie and I quite liked it. After the movie I was wondering what really made me like the movie. Was it the overall storyline, or brilliant acting by the cast or the nice direction by the director of the movie? Well, I suppose it was a mix of all the factors that made the movie enjoyable.
This also made me realize, there is a lot of similarity between a Bollywood movie and an options trade. Similar to a Bollywood movie, for an options trade to be successful in the market there are several forces which need to work in the option trader’s favor. These forces influence an option contract in real time, affecting the premium to either increase or decrease in real time.
There are six factors which affect the option premium. They are:
1. Underlying Security Price
Change in market price of an underlying security has a direct effect on Option Price. When the market price of underlying security increases, the Call Options Premiums increase while the Put Options Premiums decrease. On the other hand, when security price decreases, the Put Options Premiums increase while the Call Options Premiums decrease. Hence, we can say that the call option’s premium is directly related with underlying security price whereas put option’s premium is inversely related with underlying security price.
2. Option Strike Price
Different Strike Prices for an Option show different responses to change in market price of underlying security. Price change in Options prices is more sensitive for the Strikes which are near to the current price of the underlying security. The Strike Prices far away from the current price of the security see comparatively small change.
- As the strike price increases, the value of the call option decreases
- And as the strike price increases, the put option increases
Value of the call option is positively related with option strike price and value of put option is negatively related with option strike price.
3. Time to Expiration
Options have a limited life span thus their value is affected by the passing of time. As the time to expiration increases the value of the option increases. As the time to expiration gets closer the value of the option begins to decrease. Value of both put and call options are positively related with time to expiration.
The value begins to rapidly decrease within the last few days of an option's life. This is called as Time Decay. Some novice traders fail to recognise the importance of Time Decay, due to which they suffer losses unknowingly. Option Sellers use the Time Decay to their advantage.
4. Interest Rate
They don’t hold much significance for trading purposes. They indicate the interest rate incurred on the cost of carrying the entire trade value and the Dividend yield on it.
When interest rates rise a call option's value will also rise and a put option's value will fall.
To understand this concept, look at the decision-making process of trying to invest in IDFC ltd. while it is trading at ₹50. Say, we can buy 100 shares of the stock outright which would cost us ₹5,000.
Instead of buying the stock outright we can buy a (ATM) at the money call for ₹5.00. Our total cost here would be ₹500. Our initial outlay of cash would be smaller and this would leave us ₹4,500 left over.
We will also have the same reward potential for half the risk. Now we can take that leftover cash and invest it elsewhere such as Treasury Bills. This would generate a guaranteed return on top of our investment in IDFC. The higher the interest rate the more attractive the second option becomes.
Thus, when interest rates go up calls are a better investment so their price also increases.
On the other hand, if we look at buying a put versus a call, we can see a clear disadvantage.
The higher the interest rate the more attractive the call option becomes and when interest rates rise the value of put options drops.
Options do not receive dividends so their value fluctuates when dividends are released. When a company declares dividends, they have an ex-dividend date. If you own the stock on that date you will be receiving the dividend. On this date the value of the stock will decrease by the amount of dividend.
As dividends increase a put option's value also increases and a calls' value decreases.
Volatility is the degree to which price moves, whether it goes up or down. It is a measure of the speed and magnitude of the underlying's price changes. There are two types of volatility:
- Historical volatility
- Implied Volatility
Historical volatility refers to the actual price changes that have been observed over a specified time period. Options traders can evaluate this 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. Implied volatility can be difficult to quantify, option premiums are generally higher if the underlying exhibits higher volatility because it may have higher expected price fluctuations.
The higher the volatility, the more people will think that the stock price will move in their preferred direction. Hence, options on highly volatile stocks are expensive.