Factors affecting Option Premium

15/10/2020 0 By indiafreenotes

While Option premiums are largely a function of the strike price, spot price and the time to expiry, there are other major factors that affect the pricing of an Option. These are volatility (ups and downs in the price of the underlying stock), interest rate and dividends, if any, between the current date and the expiry date.

There are advanced models like the Black and Scholes’ model, which try to determine the price of an Option on the basis of a number of variables. These models also enable a trader to track the changes in pricing of Options as the parameters and variables used in the model change.

There are many factors which affect option premium. These factors affect the premium of the option with varying intensity. Some of these factors are listed here:

  • Price of the underlying: Any fluctuation in the price of the underlying (stock/index/commodity) obviously has the largest effect on premium of an option contract. An increase in the underlying price increases the premium of call option and decreases the premium of put option. Reverse is true when underlying price decreases.
  • Strike price: How far is the strike price from spot also affects option premium. Say, if NIFTY goes from 5000 to 5100 the premium of 5000 strike and of 5100 strike will change a lot compared to a contract with strike of 5500 or 4700.
  • Volatility of underlying: Underlying security is a constantly changing entity. The degree by which its price fluctuates can be termed as volatility. So a share which fluctuates 5% on either side on daily basis is said to have more volatility than e.g. stable blue chip shares whose fluctuation is more benign at 2–3%. Volatility affects calls and puts alike. Higher volatility increases the option premium because of greater risk it brings to the seller.
  • Payment of Dividend: Payment of Dividend does not have direct impact on value of derivatives but it does have indirect impact through stock price. We know that if dividend is paid, stock goes ex-dividend therefore price of stock will go down which will result into increase in Put premium and decrease in Call premium.

Apart from above, other factors like bond yield (or interest rate) also affect the premium. This is because the money invested by the seller can earn this risk-free income in any case and hence while selling option; he has to earn more than this because of higher risk he is taking.

The final three are numerical methods, usually requiring sophisticated derivatives-software, or a numeric package such as MATLAB. For these, the result is calculated as follows, even if the numerics differ:

  • A risk-neutral distribution is built for the underlying price over time (for non-European options, at least at each exercise date) via the selected model
  • The option’s payoff-value is determined at each of these prices
  • The payoffs are discounted at the risk-free rate, and then averaged. For the analytic methods, these same are subsumed into a single probabilistic result; see Black–Scholes model § Interpretation.