What Affects Equity Option Prices?

Option pricing is impacted by a variety of factors. Seven main components that affect the premium of an option include:

1. The current price of the underlying financial instrument
2. The strike price of the option in comparison to the current market price (intrinsic value)
3. The type of option (put or call)
4. The amount of time remaining until expiration (time value)
5. The current risk-free interest rate
6. The volatility of the underlying financial instrument
7. The dividend rate, if any, of the underlying financial instrument

Each of these factors plays a unique part in the price of an option. In most cases, the first 4 are pretty easy to determine. The others may be forgotten or misunderstood; however, each is important. Calculating intrinsic value and time value is critical to assessing option premium. Also, when it comes to trading with options, reviewing volatility levels can make the difference between successful and unsuccessful trades.

In addition, it is noteworthy to assess the current risk-free interest rate and whether or not a particular stock is prone to the release of dividends. Higher interest rates can increase option premiums, while lower interest rates can lead to a decrease in option premiums. Dividends act in a similar way, increasing and decreasing an option premium as they increase or decrease the price of the underlying asset. When a stock pays a dividend, the short seller is responsible for that payment. In contrast, the put buyer benefits from the decrease in stock price due to dividend payment.