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Chapter 1. Introduction to Options > The Seven Factors that Influence an Option...

The Seven Factors that Influence an Option’s Premium

There are seven factors that affect the pricing of an option. Again, we look to the definition of an option to give us the clues. An option is defined as the:

  • right, not the obligation

  • to buy or sell

  • an asset

  • at a fixed price

  • before a predetermined date.

Now let’s take the seven factors:

Quote from definitionComment
“buy or sell”The type of option (call or put) will affect the option price.
“underlying asset”The underlying asset and its own price will affect the option price.
“at a fixed price”The exercise price or strike price will affect the option price.
“before a predetermined date”The Expiration Date and Time Value will affect the option price.


There are three other major influences on option pricing, which we will discuss later in further detail.

FactorComment
VolatilityWorthy of a book in itself. Volatility is a crucial and major influence in the pricing of options. Understanding volatility gives the options trader the ability to select specific trades most profitably. The most advanced traders will always use volatility to their advantage.
Risk-free rate of interestThis is the short-term rate of government money. It is known as risk free owing to the perceived covenant strength of (developed world economy) governments.
Dividends payableThis applies to any asset that offers an income “reward” for owners of the underlying asset. For stock options, this will be the dividend payable.


Quick Summary

Option prices are affected by the type of option (call or put):

  1. the price of the underlying asset

  2. the exercise price (or strike price) of the option

  3. the expiration date

  4. volatility—Implied and Historical (see Chapter 6, “An Introduction to the Greeks”)

  5. risk-free interest rate

  6. dividends and stock splits

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