- Criteria for Successful Investing
- Risk Profile Charts
- The Definition of an Option
- The Valuation of Options
- Intrinsic and Time Value for Calls
- Intrinsic and Time Value for Puts
- The Seven Factors that Influence an Option's Premium
- Risk Profile Charts for Call Options
- Risk Profile Charts for Put Options
- Memory Tips for Long and Short Calls and Puts
- Basic Risk Profiles Summary
- Notation Standard for the Examples
- Chapter 1 Major Learning Points
This chapter is from the book
This chapter is from the book
This chapter is from the book
The Seven Factors that Influence an Option’s Premium
There are seven factors that affect the pricing of an option. Again, we look to the definition of an option to give us the clues. An option is defined as the
- right, not the obligation
- to buy or sell
- an asset
- at a fixed price
- before a predetermined date
Now let’s take the seven factors, which are as follows:
|
Quote from definition |
Comment |
|
“buy or sell” |
The type of option (call or put) affects the option premium. |
|
“underlying asset” |
The underlying asset and its own price affect the option premium. |
|
“at a fixed price” |
The strike price affects the option premium. |
|
“before a predetermined date” |
The expiration date and time value affect the option premium. |
There are three other major influences on option pricing, which we will discuss later in more detail.
|
Factor |
Comment |
|
Volatility |
Worthy of a book in itself. Volatility is a crucial and major influence in the pricing of options. Understanding volatility gives the options trader the ability to select specific trades most profitably. The most advanced traders always use volatility to their advantage. |
|
Risk-free rate of interest |
This is the short-term rate of government money. It is known as risk-free owing to the perceived covenant strength of (developed world economy) governments. |
|
Dividends payable |
This applies to any asset that offers an income “reward” for owners of the underlying asset. For stock options, this is the dividend payable. |
Quick Summary
Option prices are affected by the type of option (call or put) as follows:
- The price of the underlying asset
- The exercise price (or strike price) of the option
- The expiration date
- Volatility—implied and historical (see Chapter 6, “An Introduction to the Greeks”)
- Risk-free interest rate
- Dividends and stock splits