Factors Affecting Options Pricing

Any trader will confess that knowing the concept of options pricing and determining its correct value determination is essential for effective trading.

The actual price of an option is determinable when you consider all factors responsible for its price. Let’s take petroleum, for instance. The final costs of petroleum depend on consumer demand, crude oil price, seasonal changes, local and state taxes, refinery productivity, etc. When you buy or sell options and wish to know or calculate their price beforehand, you may use a mathematical formula such as the Black Scholes model. You just need to consider the model’s variables, and you will arrive at the appropriate price.

Using Options For Directional Strategies

When stock traders first begin using options, they usually purchase a call or a put for directional trading, in which they expect a stock to move in a particular direction. These traders may choose an option rather than the underlying stock due to limited risk, high reward potential, and less capital required to control the same number of shares.

If the outlook is positive (bullish), buying a call option creates the opportunity to share the upside potential without risking more than a fraction of the market value. If bearish, purchasing a put lets the trader take advantage of a fall without the margin required to sell short.

Market Direction And Value

Many kinds of option strategies can be constructed, but the position’s success or failure depends on a thorough understanding of the options: the put and the call. Furthermore, taking full advantage of options requires a new way of thinking because traders who think solely in market direction miss all sorts of opportunities.

In addition to moving up or down, stocks can move sideways or trend modestly higher or lower for long periods. They can also make substantial moves up or down in price, reverse direction, and wind up back where they started. These price movements cause headaches for stock traders but give options traders the exclusive opportunity to make money even if the stock goes nowhere. Calendar spreads straddle, strangles, and butterflies highlight strategies designed to profit in those situations.

7 Factors Affecting Options Pricing

There are several factors involved in the valuation of options. These are:

1. The Current Price of the Stock: 

This depends on logical thinking. If a call option interests you and allows you to pick up stocks of X company, say, at Rs 390 a share, then most naturally, you would be willing to pay in excess for the call above when the particular stock trades at Rs 390 as against its trading at Rs 400. This is sole because the call option gets much closer to being at an ITM of Rs 49 than it would have been if it traded at Rs 40. Put options, however, work oppositely.

2. The Strike Price :

This may be defined as the price payable by the call owner to purchase stock while a put owner decides to sell his stock. It is similar to the example cited above. One tends to pay more for the right to purchase stock at Rs 380 than Rs 400. The average investor would prefer such rights that enable him to purchase stocks at lower prices at any moment of the day. It makes calls more expensive, with the strike price moving downwards. Similarly, puts are more expensive value-wise when the strike price spirals.

3. Option Type:

The option value depends on its type. There are two types: Put or Call. The difference hinges on which side you stand in the market or trade. It is probably the simplest variable understandable to the average trader.

4. Period Before Expiry:

The influence of time is simple to comprehend, but understanding the significance of the expiration date takes practice. Because good companies tend to rise over lengthy periods, time works in the stock trader’s favor.

However, time is the adversary of the option buyer since if days pass without a significant change in the underlying, the option’s value will drop. Furthermore, as the expiration date approaches, the value of an option will decrease more rapidly.

On the other hand, this is good news for option sellers who try to profit from time decay, especially in the last month when it happens most quickly.

5. Interest Rates:

This is an insignificant factor when ascertaining the option’s price. As interest rates rise, call option values to rise too. When the trader opts for the call option as against the stock, then any extra cash in his kitty should earn interest for him, theoretically, at least. Of course, this doesn’t happen in real-world situations, but the basic theory makes sense.

6. Dividends: 

When the stock trades and yet, its holder gets no dividends, the situation is termed ex-dividend, and the stock price gets diminished by the amount of dividend payable. With rising dividends, put values increase while call values decrease.

7. Volatility: 

This is considered to be the big variable. In simpler terms, volatility is the difference recorded in day-to-day stock prices. It is also referred to as swings that affect a stock’s prices. The more volatile stocks are more frequently subject to a varying strike price level than their non-volatile counterparts. With big moves, the chances are higher to make money, and the investor shifts out of the Blue sphere. Thus options on volatile stocks are more expensive than the less or non-volatile ones. Therefore, it is always prudent to remember that even the minutest of changes in volatility estimates impact options prices substantially. Volatility is often viewed as an estimate, and using just an estimate and future volatility, particularly, makes it virtually impossible to correctly calculate the right option value.

Effect of market factors on call option price and put option price

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