What factors determine the option price, Factors That Determine Option Pricing
As a what factors determine the option price, time value is often referred to as an option's extrinsic value since time value is the amount by which the price of an option exceeds the intrinsic value. Time value is essentially the risk premium the option seller requires to provide the option buyer the right to buy or sell the stock up to the date the option expires. Typically, stocks with high volatility have a higher probability for the option to be profitable or in-the-money by expiry.
As a result, the time value—as a component of the option's premium—is typically higher to compensate for the increased chance that the stock's price could move beyond the strike price and expire in-the-money. For stocks that are not expected to move much, the option's time value will be relatively low.
One of the metrics used to measure volatile stocks is called beta. Beta measures the volatility of a stock when compared to the overall market. Volatile stocks tend to have high betas primarily due to the uncertainty of the price of the stock before the option expires.
However, high beta stocks also carry more risk than low-beta stocks. In other words, volatility is a double-edged sword, meaning it allows investors the potential for significant returns, but volatility can also lead to significant losses.
The effect of volatility is mostly subjective and difficult to quantify. When investors look at volatility in the past, it is called either historical volatility or statistical volatility.
- Effect of the value of the underlying: The call option can be viewed as buying the underlying and the put option can be viewed as selling the underlying.
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- Interest rate Dividends and risk-free interest rate have a lesser effect.
- Factors That Determine Option Pricing
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Historical volatility looks back in time to show how volatile the market has been. Implied volatility measures what options traders expect future volatility will be. As such, implied volatility is an indicator of the current sentiment of the market.
It shows the trading price of GE, several strike prices, and the intrinsic and time values for what factors determine the option price call and put options. At the time of this writing, General Electric was considered a stock with low volatility and had a beta of 0.
Comment the reason behind this is that the buyer can use his part of money for some other investment purposes when the interest rates r high in the market but paying only a margin amount of the option whereas the writer or the seller cannnot sell the goods until the buyer wishes so he is stuck with the stock and cannot convert it into cash and benefit the high rate of interest in the market. If I have an equity call that goes in my favor ie deep in the moneyyou can bet I'm going to excercise that option and take my profits. Why would I sit around and wait for the market to turn againat me and lose what ever profits I already made?
The table below contains the pricing for both calls and puts that are expiring in one month top section of the table. The bottom section contains the prices for the GE options that expire in nine months. Amazon is a much more volatile stock with a beta of 3.
Option Premium - Options Trading Concepts
Let's compare the GE 35 call option with nine months to expiration with the AMZN 40 call option with nine months to expiration.