Five main factors may influence the price of an option, also called the premium:
The strike price of the option
The market price of the underlying asset
Volatility, the price uncertainty of the underlying asset
Remaining life (the time length until the expiry date)
The interest of a loan with a term similar to the option’s remaining life
If there are payments attached to the underlying asset during the life of the contract, e.g. share dividend, the expected size and time of payment will also have an impact on pricing.
The strike price of an option
The price of an option is naturally related to the strike price. A lower strike price implies that the buyer of a call option is willing to pay more to acquire the option. Similarly, a higher strike price will cause the price of a put option to rise since the buyer of the right to sell the underlying shares may sell at a higher price.
The price of the underlying asset
The option price depends on the market price of the underlying asset. If the price of the underlying asset increases, the premium of a call option will rise and the premium of a put option will fall. If the price of the underlying asset drops, the premium of a put option will rise and the premium of a call option will fall.
Volatility
Volatility expresses the expectations to fluctuations in the price of the underlying asset. The volatility has an influence on the value of an option because it is one of the factors that determine the probability to what extent the option will end in the money, and thus the size of payoff at expiry; The higher the volatility, the higher the value of the option price. The option price will therefore rise if the volatility of the underlying asset’s market price increases.
Remaining life
The graph in the figure below shows the value of a call option with only one month till expiry. The strike price is 320. Note how the value of a call option, at a constant market price, decreases and comes closer to the intrinsic value – the option’s value if exercised immediately – as the expiry date nears.
The figure shows the value (i.e. the price and premium) of a call option with the strike price of 320 at different price levels. The top graph shows the value of the option at the time of conclusion. For example, the premium will be 20 at the price level of 320. The bottom and kinked graph shows the value of the option at expiry.
Note that the option premium’s sensitivity to price changes in the underlying asset, the slope of the top graph, is close to 1:1 when the option is deep in the money, whereas the option value only climbs very little in step with the share price, when it is out-of-the-money. The reason is that when the time to expiry is short, it is unlikely that the price will change much, which is why the option is traded at a price near its intrinsic value. If, on the other hand, the time to expiry is long, there is a greater chance that the share price will change to the advantage of the option holder.
Interest rates
Buying a call option may be considered as an alternative to buying the underlying asset. The purchase of a call option postpones the investment until the option’s expiry date, and the excess liquidity can be placed on the money market. For that reason the seller of a call option will naturally demand payment for having to finance the underlying asset during the life of the option. A higher interest rate will therefore imply a higher price on call options. The same applies to put options, the price of which will accordingly drop as interest rates go up. The interest rate level of both call and put options is, however, quite low.
