Lesson 4 – Influences on Option Prices

An option price can make the premium increase or decrease despite the share price movement. This happens because of the influencing factors of the price of an option. As a trader, you need to have an explicit knowledge concerning the influencing factors of an option’s price. Only if you understand this, you will be able to enjoy the competitive advantage when you invest or trade.  

In this part, we are going to help you understand the influences that impact the option’s value. We will also discuss the reason for the option’s value changes despite the underlying price of the share.

Most of the time, beginners get confused concerning the put and call option. They don’t understand the difference between put and call.

Basically, the put option value increases when the price of the share decreases. Likewise, the call option value increases when the price of the share increases.

So when the price of a share is increasing, the call option value is going up. Meanwhile, put option value is decreasing. On the other hand, when the price of a share decreases, the put option value is increasing while the call option value is decreasing.

Let’s take a look at the influencing factors that impact the options’ value.

A few influencing factors of option price are:

• Time to expiry
• Volatility
• Delta
• Interest rates
• Dividends

Time to Expiry

In the 3rd lesson, we discussed the Time Decay concept.

The closer an option gets to expiration, the less time value it has because there is less time for something to happen.

Even though this is appropriate for Put options, it is important to call options as well. The factor of time decay is less important for Put options because of its Interest. If you utilize a Call, you will buy shares, and this means spending money. If you don’t perform this activity, you’d be adding up your interest.

When you are purchasing a Put, you get the right to sell shares. During the sales of shares, the interest gets credited to your account. As you have cash, the factor of time decay isn’t crucial for Put options when compared to Call options.

If the time remaining for the expiration extends, the chances for the movement of underlying shares increases. To explain this in simple terms, we can put it this way. Say you are looking out of the window to predict the weather today; you’d be able to do it. However, think about predicting the weather that would be next year, this time. Can you even do it by looking out the window today? The chances for your predictions are extremely low.

This means, when you have more time to make a decision, the variations might influence your decisions further. Or if there’s less time, certainty is high.

Volatility

The next influencing factor that we are going to cover is volatility.

On expiry, the ITM would be closed because when the underlying experiences more movement creating more probability for the share price. Thus, a higher premium can be achieved through more time, resulting in increased time value.

The volatility describes the movement of the underlying price for a given time period. A person can consider this as the underlying share’s movement along with the market’s movement as an example. If Person A has a stock price that might swing 5% in a day in comparison to the 0.5% of average market swing, it will display a highly volatile stock. This example indicates that the stock is 10 times volatile compared to the underlying market.

If you are purchasing an option with a highly volatile company, you might have to pay an increased premium price. The reason is that the uncertainty is high in relation to the stock price being closed on the option contract’s expiration. There are chances for it to close up lower or close up higher. Uncertainty is the factor that creates volatility, so the writer might need more premium, while the buyer is ready to spend more as he/she would have higher potential for an option to close ITM.

So the rule is, when the volatility is high, the premium is high.

Delta

The next influencing factor that we are about to discuss is Delta.

This is the amount the price of an option will differ because of a change in the price of an underlying stock. However, when this happens, all the other factors will be equal.

For instance, assume that we are dealing with an option that has a $3.75 strike while the current share price is at $3.75. And then, ATM is the strike price. Like we discussed in the earlier lesson when the price of the share rises, the call option’s intrinsic value will also rise.   

As for the above example, if the price of the share goes up to $4.00 from $3.75, then, your call option of $3.75 will have an intrinsic value of 25 cents. However, the premium price will become higher because of Time Value. But then, the least it can be is 25 cents because of Intrinsic Value.

Similarly, if the price of the share goes up to $4.50, the Call option valued at $3.75 will have an intrinsic value of 75 cents. Or if the price goes up to $4.51 while the Call option remains at $3.75, the intrinsic value would be 76 cents. Likewise, the changes will happen.

Now, when the strike prices distance ITM, movement of 1 cent in the price of an underlying share will correlate the movement of 1 cent in the price of an option. This is represented as 1 of the Delta movement. Delta calculates the number of changes in the option price when there is a change in the price of the underlying stock. Thus, 1 of Delta is what ITM options have.

On the other hand, if we consider the same option price at $3.75 and the current price of a share at $2.50, the option would be out of money (OTM). It has no intrinsic value rather Time Value. Also, you will not be able to experience an intrinsic value unless the price of the share goes above $3.75.

Even if there were a movement of 1 cent in the price of the share, which is $2.51 from $2.50, you would not encounter many differences to the value of the OTM option at $3.75. Thus, Delta would be Zero. OTM options display Zero as Delta.

As you have studied these rules now, you can focus on merging them. And then, use it to find the way how Delta is utilized in measuring the amount of movement of a price of an option as per the price of the underlying share.  

To make it clearer, ITM options that are very deep will have Delta’s of one, and OTM options which are very deep will have Zero. This explains prices of OTM options have a minor price movement when there’s a change in the price of the underlying share.

When considering Put options, the exact opposite applies. When the share price reduces, the Put Options become more ITM. Hence, the higher the share price reduces, the higher the value of the Put Option. Thus, ITM Put options’ Delta is -1. Meanwhile, OTM put options show Zero as Delta making ATM Put Options secure -0.5 as Delta.

The takeaway is that moderately OTM options will not have Intrinsic Value. OTM options Delta for calls is near to 0.5, and for puts, it is -0.5. However, if the price of the share increases moderately ITM, there will be intrinsic value for the option price at a moderately better rate than -0.5 or 0.5. Due to this, moderately OTM options are quite inexpensive and are great for direct trading.

Interest Rates

The next influencing factor is Interest Rates.

As for the theory, the purchasing of call options delays the date of purchase of the shares underlying, offering time to think. The money otherwise has been used to purchase shares might be in the bank adding up interest. Thus, interest becomes an influencing factor of the premium price, making it slightly higher.

Dividends

Keeping this in mind, you should know that dividends will also impact the options’ price.

When an ex-dividend is imposed on a stock, which is, the company will pay the company’s share profits to its shareholders. The price of the share will automatically fall to the amount of franking credit and dividend payment.

Henceforth, a call option will increase when the share price does. So during the payment of dividends, the share price will automatically adjust downward. Likewise, the Call option’s value will also reduce.  

Due to this reason, you have to be cautious about the companies that you are trading and be considerate of the companies that handle ex-dividend.

To rewind on the influencing factors on option premium, you need to be considerate of:

• Time Value which is available until the expiration
• The volatility of the price of the underlying share
• Delta or in other words, the Option Strike/Exercise price, concerning the Price of the underlying share
• Dividends
• Interest Rates

Now that we have covered all the influencing factors let’s tie them into one.

Assume that share that you are trading is priced at $3.80; it means the intrinsic value is $0.3. So the intrinsic value is the difference between the ITM call option’s strike price and stock price. The reason for this is that the call option is valued at 42 cents, meaning there are 12 cents of Extrinsic Value of Time.

That said; let’s now consider different factors that impact the option price.

In Case 1, 10 days after, there are no changes in the option price. So, what do you think? Will the value of the option be increased or decreased? In Case 1, the option will be less worthy. The reason is that there are no changes in the Intrinsic Value, so no impacts on Delta. There have been no changes in Volatility, Dividend payment, or Interest Rates. However, there is a reduction in Time Value. So, in this case, you should assume that the price of the option has reduced to 38 cents because of the reduction of 4 cents in Time Decay.

In Case 2, there is a change in the price of the underlying share. Assume that the price has moved from $3.80 to $3.96. There are no changes to any other factors. So, what will happen to the option’s worthiness? Will it become better or worse? In Case 2, the option will increase in its worthiness. The strike level of the Call Option which is at $3.50 is Deeper ITM. It shows an increase in Intrinsic Value, and it is 46 cents now. Even though the Time Value hasn’t changed, the change in Intrinsic Value will change the option price to 54 cents.

In Case 3, there’s increased value in the volatility. This indicates that the price is changing vastly than how it was before. However, no other factors have changed. In Case 3, premium or price of the option will change. It will increase. When there’s more volatility, the uncertainty is high. Therefore, writers will focus on more premium, whereas buyers will be ready to pay a higher price than the potential of ITM. So, the option premium is now at $0.52, of course, it has increased.

In Case 4, there’s a decreased value in the volatility. This is the exact opposite of Case 3, so you have more certainty concerning the stock price movement. When there’s less volatility, there’s a lower price for an option. Thus, the call option in Case 4 has reduced to 35 cents.

In Case 5, ex-dividend has been imposed on the stock price. This means that the shareholders have been given their dividend. Meanwhile, the underlying shares’ value has reduced and resulted in a reduction of option value. Overall, the dividend payment has made the option value to decrease to 20 cents.

This is going to be our last case, but in this, we’ll include a few factors together.

In Case 6, 23 days after. The price of the share has increased, volatility has increased, and interest rate has reduced.

So the price of the share is now at $3.97, which is 23 days later. Even though there’s increased value in volatility, the interest rate has reduced. Thus, let’s focus on the influencing factors below:

• There’s an increment in the Intrinsic Value, so there will be an increment in the call value due to deeper ITM.

• There’s a reduction in the Time value.

• There’s an increment in Delta due to option distancing ITM.

• There’s an increment in Volatility.

• There is no influence due to Dividend payment

• There is a reduction in Interest Rates, which might create a good influence to Call options’ value.  

In Case 6, we have encountered that Time Decay has reduced the option’s value, but all the other factors have created a positive impact on the option’s value. So, this would create a premium increment. So in this example, it would be 50 cents from 42 cents.

You need to understand that influencing factors have the ability to increase or decrease premium despite the price of share falling or rising. Therefore, you need to understand the influencing factors of the price of an option. As said before, it will help you in achieving a competitive advantage when you invest or trade.

In this lesson, we have covered influencing factors that impact an option price’s value and the reason for an option’s value changes.

In lesson 5, we will discuss a few advanced concepts to increase your options knowledge.