Chapter 3: Factors Affecting the Price of Options Contract

Understanding Options for Directional Strategies

Options are dynamic tools in the trading world, offering traders the flexibility to tailor strategies based on market expectations. With profit potential on call and put options for both bullish outlooks and bearish scenarios, options allow for precise alignment with market predictions.

These strategies not only offer potential rewards but also bring risk control by defining both risk and reward in advance. Successfully using options for directional plays, however, requires an in-depth grasp of market movements, option pricing intricacies, and the various elements that drive these values, ultimately impacting the effectiveness of these strategies.

Market Direction and Value

While numerous option strategies exist, a successful approach hinges on understanding the two primary option types: calls and puts. To fully benefit from options trading, it’s essential to think beyond simple market direction. Relying solely on price movement misses out on many unique opportunities.

Unlike stocks, which primarily benefit from upward or downward trends, options allow traders to capitalize on a variety of price patterns. Stocks may trend sideways, rise or fall gradually, or experience significant swings before settling back. While such movements can be frustrating for stock traders, they present unique profit opportunities for options traders, even when prices stay stagnant.

Basics of Options Pricing

Successful options trading requires a deep understanding of price factors beyond simple market movement predictions. While stock traders rely primarily on price direction, options traders must consider three dynamic elements: the underlying asset price, time, and volatility. Each of these variables influences an option's value.

Option pricing models, such as Black-Scholes, binomial option pricing, and Monte Carlo simulation, use inputs like asset price, strike price, volatility, interest rate, and time to expiration to estimate an option’s fair value. By calculating the likelihood of an option ending in-the-money (ITM) at expiration, these models guide traders in building strategies that optimize returns and manage risk.

When buying an option, whether a Call or Put, the price paid is known as the premium, which consists of both intrinsic and extrinsic value components. This relationship is captured in the option pricing formula:

Option price = Intrinsic value + Extrinsic value

What is Extrinsic and Intrinsic Value?

Extrinsic Value

Extrinsic value, often called time and volatility value, reflects an option's worth based on time remaining until expiration and implied volatility. An option retains extrinsic value as long as it has time left before expiration, with this value fluctuating in response to time decay and changes in market volatility.

Intrinsic Value

Intrinsic value represents the real or built-in worth of an option based on the current market price of the underlying asset relative to its strike price. For a call option, it’s the amount the stock price exceeds the strike price; for a put, it’s the amount by which the stock price is below the strike price. Only in-the-money options hold intrinsic value.

Intrinsic value (Call Option) = Current Stock Price - Strike Price

Factors Affecting Options Prices

Several factors influence an option's value, including:

• Underlying price
• Volatility of the underlying
• Strike
• Time until expiration
• Dividends
• Interest rate
• Option Type

Underlying Price

The underlying price is the current market value of the asset on which an option is based. This price heavily influences the option’s value, as calls increase in value when the underlying price rises, while puts decrease. Conversely, a drop in the underlying price typically benefits put options and reduces call value. Movements in the underlying price, therefore, directly impact the potential profitability of an options strategy.

Volatility of the Underlying

Volatility is the degree of price variation in the underlying asset. It is an important component in option pricing, especially for an option's extrinsic (temporal) value. Higher volatility increases the risk that the option will expire in the money (ITM), which boosts the premium. Even if the underlying does not change considerably, simply anticipating huge price fluctuations (implied volatility) can cause option prices to rise.

• High volatility: Increases both call and put premiums due to greater uncertainty.
• Low volatility: Leads to lower premiums as price movements are expected to be limited.

Strike

The strike price influences an option's inherent value. It is the fixed price at which the underlying asset can be purchased (call) or sold (put).

• For calls, the further below the strike is from the current market price, the more valuable it is (in-the-money).
• For puts, the further above the strike is from the market price, the more valuable it becomes.
• Options that are at-the-money or out-of-the-money have no intrinsic value and are composed entirely of extrinsic value.

Time until Expiration

Time is an important component of extrinsic value. As expiry approaches, the temporal value of an option rapidly decreases, a phenomenon known as theta decay.

• More time to expiration: Higher extrinsic value due to greater potential for profitable movement.
• Less time remaining: Lower premium as the window for favorable price change narrows.
• This erosion accelerates as the option nears expiry, with the fastest decay occurring in the last 30 days.

Dividends

Expected dividends influence option pricing because they alter the attractiveness of holding the underlying stock versus the option.

• For call options, the anticipation of dividends lowers the option's price. This is because the stock price typically drops by the dividend amount on the ex-dividend date, making it less valuable for the option holder.
• For put options, the expected drop in stock price due to dividends can increase the put’s value.
• Dividends reduce the value of calls and enhance the value of puts, all else being equal.

Interest Rate

Changes in risk-free interest rates (such as government bond yields) affect option pricing via the cost-of-carry effect.

• Higher interest rates: Increase call option values and decrease put option values.
• Lower interest rates: Have the opposite effect — calls become less valuable, and puts more so.
• This is because buying calls (instead of the stock) allows investors to earn interest on the uninvested capital, making calls relatively more attractive in a rising rate environment. Though interest rate changes have a smaller impact than other factors, they become more relevant for longer-dated options.

Option Type (Call vs. Put)

Each of the following criteria effects the option price differently depending on whether it is a call or a put.

• Call options benefit from a rising underlying price, low dividend yields, and higher interest rates.
• Put options benefit from a falling underlying price, high dividend expectations, and lower interest rates.
• Also, calls and puts react differently to changes in volatility and time decay, making it essential to understand the nuances of each type before entering a position.
• Understanding how calls and puts respond in different market circumstances is critical for developing effective tactics.

Time Value

Time value refers to the fraction of an option's premium that exceeds its intrinsic value. It is significantly impacted by time left, volatility, and market expectations. As expiry approaches, this value depreciates, leaving just intrinsic value (if any).

• At-the-money options tend to have the <strong>highest time value</strong>.
• In- and out-of-the-money options have <strong>lower time value</strong>.
• Time value is the cost of uncertainty. The more unknowns there are, the greater the time value – until time runs out.

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