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Option pricing is based on a variety of factors. There are seven main components that affect the premium of an option.

Factors Affecting Option Prices These are:

  • The current price of the underlying financial instrument
  • The strike price of the option in comparison to the current market price (intrinsic value)
  • The type of option (put or call)
  • The amount of time remaining until expiration (time value)
  • The current risk-free interest rate
  • The volatility of the underlying financial instrument
  • The dividend rate, if any, of the underlying financial instrument

Each of these factors plays a unique part in the price of an option. In most cases, the first 4 are pretty easy to figure out. The rest are often forgotten or overlooked. However, although they may be a little confusing, each is important. For example, when it comes to trading with options, reviewing volatility levels can help traders determine the right options strategy to employ.

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In addition, it is noteworthy to assess the current risk-free interest rate and whether or not a particular stock is prone to the release of dividends. Higher interest rates can increase option premiums, while lower interest rates can lead to a decrease in option premiums. Dividends act in a similar way, increasing and decreasing an option premium as they increase or decrease the price of the underlying asset. Also, if a stock were to pay a dividend, a short seller would be responsible for that payment. This means that a short seller in securities not only has unlimited risk of the stock price rising, but also is responsible for the dividends paid out.

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