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Factors Affecting Option Value

Factors Affecting Option Value

The Factors Affecting Option value are as follows:

There are a number of different mathematical formulae, or models, that are designed to compute the fair value of an option. You simply input all the variables (stock price, time, interest rates, dividends and future volatility), and you get an answer that tells you what an option should be worth. Here are the general effects the variables have on an option’s price:

(a) Price Movement of the Underlying: The value of calls and puts are affected by changes in the underlying stock price in a relatively straightforward manner. When the stock price goes up, calls should gain in value and puts should decrease. Put options should increase in value and calls should drop as the stock price falls.

(b) Time till expiry: The option’s future expiry, at which time it may become worthless, is an important and key factor of every option strategy. Ultimately, time can determine whether your option trading decisions are profitable. To make money in options over the long term, you need to understand the impact of time on stock and option positions.

With stocks, time is a trader’s ally as the stocks of quality companies tend to rise over longperiods of time. But time is the enemy of the options buyer. If days pass without any significant change in the stock price, there is a decline in the value of the option.

Also, the value of an option declines more rapidly as the option approaches the expiration day. That is good news for the option seller, who tries to benefit from time decay, especially during that final month when it occurs most rapidly.

Factors Affecting Option Value

(c) Volatility in Stock Prices: Volatility can be understood via a measure measure called statistical (sometimes called historical) volatility, or SV for short. SV is a statistical measure of the past price movements of the stock; it tells you how volatile the stock has actually been over a given period of time.

Factors Affecting Option Value

But to give you an accurate fair value for an option, option pricing models require you to put in what the future volatility of the stock will be during the life of the option. Naturally, option traders don’t know what that will be, so they have to try to guess. To do this, they work the options pricing model “backwards” (to put it in simple terms). After all, you already know the price at which the option is trading; you can also find the other variables (stock price, interest rates, dividends, and the time left in the option) with just a bit of research. So the only missing number is future volatility, which you can calculate from the equation.

(d) Interest Rate– Another feature which affects the value of an Option is the time value of money. The greater the interest rates, the present value of the future exercise price are less.

Factors Affecting Option Value

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