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Wednesday September 08, 2010 |
Understanding
Price - Factors
Effecting Premium
There
are many factors that effect option premium prices. Of course there are the obvious factors like the price of the
underlying security and time but there are several not-so-obvious
factors like the risk free level of interest rates. In this short lesson we will take a look some of these
factors.
The
Underlying Security Price
This
is the most obvious and most important factor governing option
premium prices. Because
options are derivatives they do not have value in their own right. All value for options are directly derived from the price
movements of the underlying security. An IBM November 100 call only has value if
the IBM common stock
rallies above $100. We
have already covered this factor in detail.
The
Strike Price, Intrinsic Value
Let
us not forget the importance of the difference between the
underlying asset price and the contract strike price and in the
determination of option premium prices. The in-the-money portion, or intrinsic value of the option
premium is often the largest component of premium and is directly
related the strike price of the option contract. In-the-money options (those with high intrinsic values)
will always be more valuable than at, or out-of-the-money options.
Time
Until Expiration, Time Value
Just
as intrinsic value plays a large role in the price of option
premiums, so too does the value of time. In many cases when volatile is high, time value can be
exceptionally high. This
portion of the option premium will often fluctuate wildly but as
the option contract nears its expiration date this time value shrinks
dramatically.
Dividends
and Interest Rates
Option
investors often overlook both dividends and risk free interest
rates but it is important to note that both factors can play a
role in option premium pricing.
If
a stock has a high dividend rate there is a good chance volatility
for the underlying security will be lower than those firms that
devote the lion's share of their revenues to growth.
This
is important because investments are attractive only when compared
to other investment cases. Options
are no exceptions to this very basic principle. If interest rates are relatively high investors may choose
to avoid stocks and options in favor of the risk free investment.
A
second way that interest rates effect option pricing is tied to
volatility. Relatively high interest rates often lead to lower
growth rates – of course low growth rates have an inverse effect
on volatility – more on this very important factor in our next
lesson.
understanding
price 
volatility
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