OPTION PRICING: How Is Option Priced? (Part 1)

Option price does not always move in conjunction with the price of the underlying stock. As such, it is important to understand what factors contribute to the movement in the option price, and what effect they have.
There are 6 factors that affect option price:

1. OPTION STRIKE PRICE
Strike price determines whether an option is In-The-Money, At-The-Money, and Out-Of-The-Money.
The more deeply In-The-Money (ITM), the higher the option price will be, as it carries more intrinsic value.
The further an options is Out-Of-The-Money (OTM), the lower the option price will be.

2. CURRENT STOCK PRICE
This factor has opposite impact on call and put (assuming all other factors kept constant):
When stock price increase, Call premium will increase and Put premium would decrease.
When stock price decrease, Call premium will decrease and Put premium would increase.

3. TIME (NUMBER OF DAYS) REMAINING UNTIL EXPIRATION
This factor affects the Time Value component of an option price. All other things being equal, an option with more days to expiration will have more Time Value component than an option with fewer days to expiration.
In general, for both Calls & Puts, the Time Value component of an option price decreases or “erodes” as expiration is nearing (often called “Time Decay”). And the Time Value component would decrease at an accelerating rate as it is getting closer to expiration, particularly for At-The-Money (ATM) option.
Due to time decay effect, even though a stock price, say, just remains constant till expiration, an Out-Of-The-Money (OTM) option price which contains only time value will decrease over time and then expire worthless. Therefore, time is the enemy of options buyers, but a friend for options sellers.

4. IMPLIED VOLATILITY (IV)
Volatility is a measure of risk / uncertainty of the underlying stock price of an option. It reflects the tendency of the underlying stock price of an option to fluctuate either up or down. Volatility can only suggest the magnitude to the fluctuation, not the direction of the movement of the price.
Implied Volatility (IV) here is an estimate of future volatility. Since it is only an estimate, it is the most subjective and probably the most difficult factor to quantify. Nevertheless, IV can have a significant impact on the time value component of an option's premium.
Higher Implied Volatility reflects a greater expected fluctuation (in either direction) of the underlying stock price, and as such it is more likely that the underlying stock will move in your favor.
As a result, the higher the Implied Volatility of the underlying stock, the more expensive its options (both Calls & Puts) will be, because there is a greater possibility that the options will end up in your favor profitably.

5. INTEREST RATE
The impact of interest rate on option’s price has something to do with the “carrying cost” of stocks. When you are bullish on a certain stock, it is much cheaper to buy Call option than the stock itself. The interest cost should you buy the stocks is built into the Call option’s value.
In this case, all other things kept constant, an increase in interest rates will lead to an increase in Call premiums and a decrease in Put premiums.
However, in reality, all other things rarely remain constant. An increase in interest rates will generally result in a drop in stock prices, and this impact would often overwhelm the effect of interest rate on option price. Therefore, the impact of interest rate on option’s price is not certain, depending on the combined effects of the change in stock price (due to interest rate changes) and the “carrying cost” effect.

6. DIVIDEND
A stock price is expected to drop by the amount of the dividend on the ex-dividend date. Hence, high cash dividends imply lower call premiums and higher put premiums.

Continue to Part 2