Factors affecting the option premium

      There are number of factors which influence an option’s price. These factors either help one to make profit or hurt one to make loss.

 These factors are following,

 1. Stock price

       Stock price is the prevailing market price of the underlying. When a call option is exercised, the payoff which will result there from will be the difference between the stock price and the exercise price. So, we can say that a call option is more valuable when stock price rises and less valuable when it falls. While for a put option, it is more valuable when stock price falls and less valuable when it rises. The payoff for any option will be the difference between exercise price and the stock price or 0 whichever is more.

 2. Exercise price

       Exercise price is the price in the contract. A call option with a higher exercise price can not be expected to be valued higher than another call with the same parameters but with a lower exercise price. To understand this let us take an example. Suppose two calls on a stock with different exercise dates have exercise price of Rs. 200, and can be in the same position as the holder of the other call who could buy the same at Rs. 220, plus the cash left over. So, it is obvious that the call with a higher exercise price can not be valued higher.   

 3. Length of Time of Expiration

       Time to expiration is the difference between today’s date & the maturity date. (Maturity date is the date on which all the contracts expire. In other words, all the obligations on the futures or options contract are fulfilled on that date). The effect of time to expiration widely depends upon type of the options. As we know there are two types of options, one is American style (an option which can be exercised on any working day till maturity date) e.g. stock options and other is European style (an option which automatically gets exercised on the maturity date) e.g. index options. As the time to expiration increases, the American call and put options become more valuable. The logic behind that is, if we take two calls on the same stock but with different exercise prices and with different exercise dates, it can be easily visualized that the option with the longer life would offer all the exercise opportunities to the investor, then the option with a shorter life and some additional benefits also. So it is appropriate to say that of the two comparable calls, the one with a longer life will not be lower than the one with a shorter life.
      Still, it is not necessary that the European call and put options become more valuable with the increase in the time to expiration. This is so because the holder of the option with longer life does not enjoy all opportunities open to the owner of the one with a shorter life since the option can be exercise only at maturity.

 4. Dividend

       Dividend on stock reduces the stock price on ex-dividend date. Therefore, this will effect the value of call options adversely and of put option favorably. The effect on option prices are related to the amounts of dividends expected.

 5. Interest Rate

       A risk free interest rate has no direct impact in the option prices. Increase in risk free interest rate leads to an increase in expected growth rate in the stock option prices, while decrease in the present value of any cash flows received by the holder of the option. The first of the two effects has a large impact on the call option than the second one, with the result that a call option price would increase with an increase in the risk free interest rate. But both of them have adverse impact on the value of the put options.

 6. Volatility

       Volatility, a major factor which affects the price of the option, is the degree of which price of a stock or an index tends to fluctuate over a certain period of time. As volatility increases the chance that the stock would perform very good or very bad also increases. These two outcomes tend to have an offsetting effect on the holder of the stock. But the situation will be different for the owner of a call or put option. The owner of the call would be benefited from the increase in the price of the stock but his bottom-line risk the option premium. In the same way, the owner of a put option profits from a decrease in the stock price and his risk in the case of upward price movement is limited.