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Understanding Option Pricing and Factor Affecting Option Pricing

Understanding Option Pricing and Factor Affecting Option Pricing

If an investor is wishing to start trading in Options then he must have a good understanding of Options Pricing and there are certain factors that play a very important role in establishing the value of an option. There are various option pricing models that are used to identify the value of a call or a put option. The trader can take the advantage of the price movements and optimize their earnings from their investments efficiently only if they carry a great understanding about the Option Pricing.

Option Pricing

The Options pricing is simply the amount per share you have to pay to trade an option. The price of an option is termed as the premium. The option buyer has to pay the premium amount to the seller to earn the rights granted by the Options. The Options premiums are priced per share. They are available in lots of shares termed as the lot size. The customers need to pay:

Total Premium Amount= (premium per share) x (lot size)

Factors that determine the Option Price

There are certain factors that influence the price of an Option:

  • Stock Price: In case a call option allows the trader to buy a stock at a specified price in the future then the higher the price goes, the more will be the options worth.
  • Strike Price: This price goes the same way as the Stock price. The strikes are classifying as in-the-money, at-the-money or out-of-the money. A call option is in-the-money means that the stock price is higher than the strike price. A call-out-of-the-money means that the stock price is less than the strike price. The options that are in-the-money have high value as compared to the options that are out-of-the-money.
  • Types of Option: An Option is either a put or a call. A call option provides the holder the right to buy the underlying at the specified price within a specific time period. A put option provides the holder the right to sell the underlying at a specific time period. If the trader is long a call or short a put then the option value increases as the market moves higher. If the trader is long a put or short a call then the option value increases as the market moves lower.
  • Volatility: This is the only estimated factor of this model. Forward Volatility is used for this model and it is the measure of the implied volatility over a certain time period in future. The implied volatility describes the implied movement in the stock’s future volatility. It explains the trader’s expectancy of the stock’s movement. The implied volatility is always expressed as percentage, non-directional and on the annual basis. Higher the Implied volatility, more the trader’s expectancy on stock price will move.
  • Dividends: The value of Options fluctuates as they do not receive dividends. When a firm releases dividend, they have an ex-dividend state. In case the trader owns the stock on that particular date then he will receive the dividend. Also, the value of the stock will decrease by the dividend amount. A put options value increases and a call options value decreases only if there is a rise in the dividends.
  • Intrinsic Value of an Option: This value refers to the value of an option if it was exercised today. This value is calculated as the difference between the price of the underlying instrument from which the options are derived and strike price. The strike price is the price at which a buyer and a seller decides to enter the contract. For call Options, Intrinsic Value= Spot Price – Strike Price For put Options, Intrinsic Value = Strike Price- Spot Price The intrinsic value of an instrument can either be positive or zero. It never turns to negative. This value helps in determining the profit advantage in case the trader wishes to exercise the options immediately. This is also termed as the minimum value of an Option.
  • Time Value of an Option: This is calculated as the difference between premium and intrinsic value. Time Value= Premium – Intrinsic Value. The time value is directly related to the time an option has till it expires. Longer the time for an option to expire, higher is the premium and it gradually decreases as the expiry of an Option comes closer.