DERIVATIVE SEGMENT – 11

BASICS OF OPTION PRICING

SPOT PRICE OF THE UNDERLYING ASSET – The option premium is affected by the price movements in the underlying instrument . If price of the underlying asset goes up the value of the call option increase while the value of the put option decrease, vice-versa ..
STRIKE PRICE – If all the others factors remain constant but the strike price of option increases , intrinsic value of the call option will decrease and hence its value also decrease . on the other hand , with all the other factors remaining constant , increase in strike price of option increases the intrinsic value of the put option which in turn increases its option value.
VOLATILITY – It is the magnitude of movement in the underlying assets price , either up or down . It affects both call and put options in the same way . Higher the volatility of the underlying stock, higher the premium because there is greater possibility that the option will move – in – the – money during the life of the contract.

TIME TO EXPIRATION – The effect of time to expiration on both call and put options is similar to that of volatility on option premiums . generally , longer the maturity of the option greater is the uncertainty and hence the higher premiums . If all other factors affecting an option’s price remain same , the time value portion of an option’s premium will decreases with the passage of time . This is also known as time decay . Options are known as ‘wasting assets ‘ , due to this property where the time value gradually falls zero
INTEREST RATES – Interest rates are slightly complicated because they different options, differently. For example, interest rates have a greater impact on options with individuals stocks and indices compared to options on futures . To put it in simple way high interest rates will result in an increase in the value of call option and a decrease in the value of a put option.

Sourced by

GOWRISH R BHAT .