Anyone who has studied options knows that there are six basic factors that make up the price of an option. They are, the price of the underlying, strike price, days until expiration, dividends, interest rate and volatility. I thought this might be a good time to review all of these factors and how they influence an individual options price. I am choosing to do this review in more of a straight forward way rather then a purely mathematical way. There are many excellent books that use great mathematical models in explaining options, but I believe that for terms of a review we can look at some real life examples and learn from those situations. The purpose of this review is to help you to make better decisions on which options to purchase and which ones to write.
The first two factors of the underlying price and the strike price are both the easiest to illustrate and to understand. I will use General Electric (GE) stock for example purposes. When GE stock is trading at $36, then it is evident that the 35 Call is intrinsically worth $1 and the Put has no value at all, whereas the 40 Call has no value and the 40 Put is intrinsically worth $4. Should GE have a rally and trade $39 the 35 Call is worth $4, the 35 Put still has no value. The 40 Call is still worthless and the 40 Put is now only worth $1. This example shows very quickly how the underlying price will quickly influence the price of the options. As you can also see the Strike Price that is chosen also will have a direct effect on the pricing of the option.
The concept of days until expiration having an effect on the pricing of options is really one of common sense as much as anything else. When looking at two time frames the longer term one will hold a higher price as a greater time is equal to greater risk. Even if we ignore the interest rate component of things for a moment and go back to our GE example this is easily illustrated. Using a date of August 15, if GE is trading at $37 and we are looking at buying the September 40 call or the December 40 call the December 40 call is going to cost more as there is a greater risk to the Call writer that the Dec 40 Call is going to finish in the money. The call buyer gets to participate in three more months of movement and potential profits.
Dividends are sometimes easily overlooked as a factor but they are something that should be thoroughly researched before trading an option. Although past dates of dividends and the amount paid are easily found, companies do sometimes change both the date and amount of the dividends so this is something which one should always keep reviewing. There are many different scenarios here so we will say that one should realize that if GE pays a $1 dividend annually, and they go ex-dividend quarterly that the stock is going to lose a quarter on those days. This means that there has to be an extra $.25 built in to the deep puts so that they can be in line with the stock on ex-dividend date.
Interest rates are something that has been in the news lately with the actions of the Federal Reserve, and they are one of the factors in pricing options. The quickest and most common sense to look at how rates influence pricing is this, as interest rates increase it becomes more attractive to own calls as they are a cheaper alternative to carrying the stock. Using the case of GE trading at $36, it would be much cheaper to buy a GE 30 Call for $6 and carry that then it is to pay the carrying cost on stock. As an investor one has to figure if it will be cheaper to pay the extra premium above $6 that will be necessary as you go out in time or if it is cheaper to carry the stock outright.
The final factor in options pricing and the one that is certainly the hardest to understand is the concept of volatility. By definition volatility is expressed mathematically as an annualized standard deviation of returns. Volatility is so difficult because you can only look at it in the past and the past volatility in options is not necessarily a good way to predict the future volatility. Although volatility may often trend one way or another, world events (such as a plane crash) as well as internal company events (bad earnings) can send a companies volatility soaring in a matter of minutes. Then there are other times when a stock is in a tight trading range for a matter of months and the volatility comes in some every day. An example of this would be if GE stayed in a trading range of $34 to $36 for 6 months you would see the options from all time horizons being affected. The short term all the way to 3 years out would be significantly cheaper after those 6 months them they were earlier as you could see volatility in 4 to 6 points. There are many web sites from which you can follow implied volatilities of options, which makes it much easier to make good decisions.
As you go forward trading options these factors are good to keep reviewing so that you can see how the options you trade are moving because of them. You will be a much better trader if you realize that a company increasing their dividend is going to increase the price of a deep Put. Knowing the reasons that options move will give you an edge on every trade and hopefully lead you to greater profitability.