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Optionetics Trading Education Center
What Affects Equity Option Prices?
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DirectionalTrader
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Option pricing is based on a variety of factors. There are seven main components that affect the premium of an option. These are:
- The current price of the underlying financial instrument
- The strike price of the option in comparison to the current market price (intrinsic value)
- The type of option (put or call)
- The amount of time remaining until expiration (time value)
- The current risk-free interest rate
- The volatility of the underlying financial instrument
- 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 figure out. The rest are often forgotten or overlooked. However, although they may be a little confusing, each is important. For example, when it comes to trading with options, reviewing volatility levels can help traders determine the right options strategy to employ.
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. Also, if a stock were to pay a dividend, a short seller would be responsible for that payment. This means that a short seller in securities not only has unlimited risk of the stock price rising, but also is responsible for the dividends paid out.
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