Factors That Affect The Price Of An Option Stock

Have you ever wondered how the option traders arrived at the price of the options? Contrary to what many people think, the prices of options are not just fused on them. Arriving at this price takes a rigorous process of using many variables and input. Also, as a stock trader, you can't know the price of an option without first knowing the factors that determine the price. Understanding these factors and mastering the concept behind them can help you decipher the price of the option. 

The price of an option is determined the same way the price of most things like petroleum is determined. To find out the price of petroleum, factors like the price of crude oil, current consumer demand, refinery productivity, and seasonal changes would be taken into consideration. In the same vein, to find out the price of an option, factors such as interest rate, stock price, strike price, and volatility would be taken into considerations. Arriving at a substantial result would require the use of mathematical formulas such as Black Scholes model. Before examining the factors that determine the price of an option, the meaning of option itself would be examined. 

What Is An Option?

An option is a derivative contract that allows one to buy and sell some specific assets for a stipulated amount before the contract expires. Stock traders who engage in the buying and selling of options usually used this as a way to hedge against market risks. When the contract is issued, the next action is to determine the price of the option. The price of an option is usually calculated using mathematical models such as the Black Schole Model. However, the direct input of the option price is determined by other factors such as the price of the underlying asset, interest rate, expiration period, and volatility.

The Fundamentals Of Option Pricing

Most times, when an option trader master the act of predicting the movement of stock, he or she feels this is all there is to know about option price. However, this is not the truth. Before settling for an option price, the option traders would have to first understand the necessary conditions and complexity of choosing the right strategies and the additional variables that affect the option price. There are three basic shifting conditions all options traders must understand. These conditions include underlying security price, volatility, and time. Any slight changes in any of these three variables affect the price of the option.

The three shifting conditions listed above sfe used to arrive at a theoretically value an option. These variables help to provide an estimation of an option fair value that traders incorporate into their strategies in order to make more profit from the sale of the option.  Some of the models that are commonly used to calculate option pricing include Black Schole, Monte Carlo Simulation, and Binomial option pricing. These models are mathematical formulas designed to compute the fair value of an option. All that is required of the trader is to input known variables. When the trader do this, he or she would be given an answer describing what the option should be worth. Since these models make use of the price of common stock in their calculation, there is a wide margin for errors. 

The major aim of any option pricing model is to find out the probability that an option will be-in-money (ITM) after it's expiration. To find out the fair value of the option, some of the variables that would be entered include stock price, strike price, type of stock, interest rate, volatility, and expiration time. The expiration day is determined by finding out the number of days between the calculation day and the option's exercise date. The major effect these variables have on the option price would be explained in detail below:

• Stock price

A change in the price of an underlying stock would affect the value of the option call and put. This implies that, when there is an increase in the value of a stock, the call option becomes more profitable because the underlying asset is now affordable. As the value of the call increase, the value of put decrease. In the same vein, an increase in the value of put will result in a decrease in the value of the call. This increase and decrease in the value of call and put is determined by the change in the value of underlying assets.

• Strike price

The predetermined price of an underlying asset is called the exercise price or the option's strike price. The strike price is classified as in-the-money, out-of-the-money, or at-the-money. 

On the one hand, when the call to buy an underlying asset is in-the-money, it means that the current price of the asset is higher than the strike price. If the call to buy the asset is out-of-the-money, it means that the strike price is more than the underlying price of the asset. For instance, an underlying asset might be currently selling for $60 but has a call at the strike price of $40, this type of option is in-the-money. 

On the other, a put option is in-the-money when the strike price is lesser than the underlying price. Therefore, options that are in-the-money have a higher value when compared to options that are out-of-the-money

• Type of Options

The major type of option has been mentioned in our explanations so far. An option can either be a call or a put. The value of a call option is different from the put option. 

• A call option is an option that gives the contract holder the opportunity to buy an underlying asset for at a specific price and at a specific period of time 
• The put option allows the holder to sell an underlying asset for a specific price and at a specific period of time.

• Time of stocks option Expiration

The effect of time on stock and options cannot be underestimated. Time could work in favor of the stock trader when the market is on the rise. Time also affect the popularity of good companies. This is because good companies tend to rise after a long period of time. 

However, it is important to note that option are not like stocks. Options have a limited lifespan and are more affected by time than stock. The expiration period of a call option and a put option can affect the price of the option. While time works to favor the options trader, it does not for the option buyer. For the buyer, as each day passes, the value of the option would decline. When the option begins to approach its expiring date, the value declines more rapidly. This period only favor of the option seller. 

• Interest Rates

The interest rate of an option can also be affected by the change in the interest rate of an underlying asset. When interest rate is on the rise, call options benefits from this but put loses value. However, when the interest rate is on the decline, put option benefit but call loses value.

• Dividends

There is no dividend on option, but the value of option can fluctuates when there is an increase in the dividend. Whenever a company releases dividends, an ex-dividend date is released alongside. If you own stocks in such a company, you will receive a dividend on the day attached to the release. Also, on this day, there would be a decrease in the value of the stock by the exact amount in dividends. This change in the value of stock inadvertently affect the value of options. Hence, as dividend increases, the value of the put option also increases, however, the value of the call option would decrease.

• Stock Option Volatility

Oftentimes, what beginners finds difficult to understand among the factors that affect the price of an option is volatility. There are different types of volatility that usually affect the price of stocks and asset. The type of volatility used in determining the price of an option is called the statistical volatility. Statistical volatility or SV for short is a measurement system that focuses on the historical price of the stock and how the price has been affected by other factors for a given period of time. 

The pricing model of an option often requires that the options traders enter a future volatility study. Since most options traders don't understand what this is or what it implies they usually do a backward study of the price of options. After all, the option traders already have a way of guessing the option price and how to examine other variables like the interest rate, dividend, and time of expiration. Hence, the missing factor in determining the price of the option is future volatility which can easily be examined by noting the input of other variables. 

It is these inputs that are used to form the basis of what is known as implied variables. This is called implied variables because it allows the traders to have a clue of what future volatility could be.

Option traders use implied volatility to guess if options are cheap or expensive. Most times, we hear option trader use terms like the premium level are low and the premium level is high. What this implies is that the current implied volatility is low or high. 

Once a trader understand how to determine the future price of options by using the implied volatility, they would be able to determine the best time to buy and sell an option

Importance Of Buying And Selling Options

• Directional Strategies

One of the major reasons stock traders engage in the buying and selling of options is directional tradings. Directional tradings refers to the use of option to move the price of stock in a particular direction. Traders who engage in options for this purpose do this because of the high risk in stocks and the high reward and less capital in options. 

• Beneficial To Both Sellers And Buyers

If the economic outlook of the stock is bearish, that is if it is a bear market outlook, buying the put option would allow the trader to take advantage of a fall without the margin required to sell short. However, if the outlook is positive or bullish, that is, if it is a bull market, buying the option call allows the buyer to have a share in the upside potential without having to risk more than a fraction of the market value. 

• Options Can Trigger Stock To Trend

There are different types of options strategies, however, the two most common ones are the call option and the put option. 

Aside from this, relying solely on the market directional value of option allows one to miss out on the important advantages of option stock. This is because aside from the up and down movement of the stock, an option can trigger stock to trend for a given period of time or move it sideways. 

Option can also make substantial moves up and down in price then reverse backward or wind up to where it begins. However, this kind of movement can have a negative effect on the value of the stock but offer the option traders the exclusive opportunity to make more money. Some option strategies that are designed to make money through this means include butterflies, straddles, calendar spread, and strangles.

Summary

Understanding how option price is determined is quite complex, especially when it comes to volatility. However, once a stock trader understands how the option works, the process of determining the present and future price of an option becomes very easy.