Explained: Factors that affect the pricing of option premium

For the uninitiated, options are derivative contracts whose value is derived from an underlying asset.

For the uninitiated, options are derivative contracts whose value is derived from an underlying asset. And option premium is the price at which these contracts are bought or sold. 

In this post, we shall understand the factors that affect the options premium.

A) Spot price - Spot price refers to the current price at which the underlying security can be bought or sold in the markets. A rise in the spot price causes the call option premiums to increase because the buyer of the call option is bullish and the rise in spot price reaffirms that the markets are going in the expected direction. On the other hand, a rise in spot prices results in a reduction in put option premium because the buyer of the put option is bearish and the markets are going against his expected direction. 

B) Strike price - Strike price refers to the price at which the derivative contract can be bought or sold if the buyer of the option decides to exercise his rights. An increase in the strike would reduce the value of the call option premium because as a buyer you would like to buy at a cheaper rate. On the other hand, an increase in the strike price increases the value of the put option premium because as a buyer you would prefer to sell at a higher price.   

C) Maturity period - Maturity period refers to the time frame within which the options shall expire. The maturity period has a positive relationship with both call option premium as well as put option premium. This is because a higher duration increases the likelihood of stock prices hitting the desired targets of option buyers, enabling them to exercise their rights. 

D) Volatility - Volatility refers to the degree to which the stock price will fluctuate within a period. It reflects the speed and magnitude with which the stock price will move in either direction. Volatility, which can be either historical or implied, has a direct relationship with option premiums. This is because the higher volatility increases the chances of stock price hitting the target at the same level of risk (the maximum loss that a buyer of an option can incur is the option premium). 

E) Interest rates -  A rise in the interest rate causes the call option premiums to increase. On the other hand, it causes the put option premium to decrease.  

F) Dividends - Option buyers do not receive dividends as buying the option does not make you the owner of the stock. Put options have a direct relationship with dividends, that is, an increase in the stock dividend will cause the put option premiums to rise. On the other hand, call options have an inverse relationship with dividend payments, that is, an increase in the stock dividend will cause the call option premiums to decrease.