Factors affecting Option Prices

Factors affecting options value

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2. 3.

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5. 6.

Stock Prices (So) Exercise Price (E) Time to Maturity (t) Dividend (D) Risk Free Rate (r) Volatility in Stock Prices ()

1. Stock Prices (So)

Call Option: - When Exercised (naturally when So is higher) Pay off = So E, thus higher the So greater is the pay off & less valuable when So decreases . i.e. if So is less than E, call will not be exercised.

For a Put Option: - Pay off = E- So Therefore the holder of put option will exercise his rights to sale only when market price is lower and exercise price is higher. So that he can buy at less price and sell at higher price hence pay off for put option is E- So i.e we can say that lesser the So for a given exercise price, higher will be the value of a option.

2. Exercise Price (E)

A call option with higher exercise price cannot be valued higher than another call with the same parameter but with a lower exercise price. For Example: suppose two calls on a stock with identical exercise dates have a exercise price of Rs. 180 and Rs. 190 respectively. The holder of the former call can buy the underlying security at Rs. 180, and can be in the same position as the holder of the other call who could buy the same security at Rs. 190, plus the cash left over.

3. Time to Maturity (t)

The effect of time on the value of the option depends on whether the option is American or European. The American Call & Put Option are more valuable as the time to expiration increases. For example: 2 Calls with same exercise price but with different expiry dates the one with longer life gives the investor all the opportunities compared to the one with shorter life. Therefore we can say that a Call or Put Option with longer life will be valued higher than the call with a shorter life.

Whereas in the case of European call or put options which can be exercised only on maturity date, the owner of an option with longer life does not enjoy all the opportunities compared to one with shorter life For eg. If an investor has two call options- one with an expiration date in one month and the other in two months and a dividend is expected in a month and a halfs time, then price of the stock is likely to decline by the second month. Thus we can say that the option with smaller duration has a value greater than the value of the longer expiry period.

4. Dividend (D)

Dividend on stock have the effect reducing the stock price on exercise dividend date. Therefore this affects the value of call option adversely and of put option favorably. And the effect on option value depends on the amount of dividend expected. Dividends cause stock prices to reduce by the amount of dividend paid ie., the payment of a dividend yield at rate q therefore causes the growth rate in the stock price to be less than it would otherwise be by an amount q.

5. Risk Free rate (r)

or

Interest Rate (r)

Risk free rate has positive relationship with the value of call option. The higher is the interest rate higher is the stock option price. This is so because the final payment for the purchase of the shares is delayed till the time the option is exercised at some future date. The higher the Rf the lower is the PV oof exercise price, since the this price is to be substracted from So, the value of option increases. OR we can say the PV of exercise price will be less with higher discount rate causing higher value of So

6. Volatility in Stock Prices ()

Volatility in the share price significantly influences the call option value. i.e. the greater the possibility of extreme outcomes, the greater is the call option value to its holder, all other things remaining constant. Or We can say, the greater is the variance/Standard Deviation, the more is the worth of the option to its owner.