6.5.3.

Determinants of the Option Price The factors that affect the price of an option include:

Market price of the underlying asset.

Strike (exercise) price of the option.

Time to expiration of the option.

Expected volatility of the underlying asset over the life of the option.

Short-term, risk-free interest rate over the life of the option.

Anticipated cash payments on the underlying over the life of the option.The impact of each of these factors may depend on whether (1) the option is a call or a put,and (2) the option is an American option or a European option. Market price of the underlying asset. The option price will change as the price of theunderlying asset changes. For a call option, as the underlying assetss price increases (allother factors being constant), the option price increases. The opposite holds for a putoption, i.e. as the price of the underlying increases, the price of a put option decreases. Exercise (strike) price The exercise price is fixed for the life of the option. All other factors being equal, thelower the exercise price, the higher the price for a call option. For put options, the higherthe exercise price, the higher the option price. Time to expiration of the option. After the expiration date, an option has no value. Allother factors being equal, the longer the time to expiration of the option, the higher theoption price. This is because, as the time to expiration decreases, less time remains for theunderlying assets price to rise (for a call buyer) or fall (for a put buyer), and therefore theprobability of a favorable price movement decreases. Consequently, as the time remaininguntil expiration decreases, the option price approaches its intrinsic value. The impact of longer remaining life is shown in Figure 22 Figure 22 .

Impact of longer remaining life on the value of a call option Figure 23 . Impact of the volatility of the underlying asset on the value of a call option C 2 has a longer life than C 1 Mertons bound is higherfor C 2 because D 2 <D 1 C P C 2 P ED 2 PE C 1 P ED 1 EC 2 PECP EDC 1 C 2 has greater volatility of underlying assetP E

138 Expected Volatility of the Underlying asset over the life of the option. All other factorsbeing equal, the greater the expected volatility (as measured by the standard deviation orvariance) of the underlying, the more the option buyer would be willing to pay for theoption, and the more an option writer would demand for it. This occurs because the greaterthe expected volatility, the greater the probability that the movement of the underlying willchange so as to benefit the option buyer at some time before expiration. Figure 24 . Impact of higher interest rate on value of call option

Short-term, risk-free interest rate over the life of the option. Buying the underlyingasset requires an investment of funds. Buying an option on the same quantity of theunderlying makes the difference between the underlyings price and the option priceavailable for investment at an interest rate at least as high as the risk-free rate.Consequently, all other factors being constant, the higher the short-term, risk-free interestrate, the greater the cost of buying the underlying asset and carrying it to the expirationdate of the call option. Hence, the higher the short-term, risk-free interest rate, the moreattractive the call option will be relative to the direct purchase of the underlying. As aresult, the higher the short-term, risk-free interest rate, the greater the price of a call option. Anticipated cash payments on the underlying over the life of the option cash paymentson the underlying tend to decrease the price of a call option. The cash payments make itmore attractive to hold the underlying than to hold the option. For put options, cashpayments on the underlying tend to increase the price. 6.5.4. Option pricing models An option pricing model uses a set of assumptions and arbitrage arguments to derive atheoretical price for an option. Deriving a theoretical option price is much morecomplicated than deriving a theoretical futures or forward price because the option pricedepends on the expected volatility of the underlying over the life of the option.Several models have been developed to determine the theoretical price of an option. Themost popular one was developed by Fischer Black and Myron Scholes (1973) for valuingEuropean call options on common stock.CCCPC has a higher interest rateP EDP EDP E

139 6.5.5. Mixed strategies in options trading

Call and put options and the buying and writing of options can be combined to try to profitfrom expected conditions in the market. Some of such strategies are as follows: Cases where a trader either buys or writes options but does not do both Straddle a call and a put at the same strike price and expiry date Strangle a call and a put for the same expiry date but at different strike prices Strap two calls and one put with the same expiry dates; the strike prices might be thesame or different Strip two puts and one call with the same expiry date; again strike prices might be thesame or differentIn general, the buyer of these options is hoping for market prices to move sharply but isuncertain whether they will rise or fall. The buyer of a strap gains more from a price risethan from a price fall; the buyer of a strip gains more from a price fall. The writer in allfour cases is hoping that the market will remain stable, with little change in price duringthe life of the option. Spreads: combinations of buying and writing options Butterfly buying two call options, one with a low exercise price, the other with a highexercise price, and writing two call options with the same intermediate strike price or thereverse. Condor similar to a butterfly, except that the call options which are written havedifferent intermediate prices.Both a butterfly and a condor are vertical spreads all options bought or sold have thesame expiry date but different strike prices. Horizontal spreads have the same strike pricesbut different expiry dates. With diagonal spreads both the strike prices and the expiry datesare different. Other mixed strategies have equally improbable names. They include verticalbull call; vertical bull spread; vertical bear spread; rotated vertical bull spread; rotatedvertical bear spread.