What Affects
Stock Option Prices?
Option pricing is based on a variety of factors. There are seven main components
that affect the premium of an option. These are:
1. The current price of the underlying financial instrument.
2. The strike price of the option in comparison to the current market price
(intrinsic value).
3. The type of option (put or call).
4. The amount of time remaining until expiration (time value.
5. The current risk-free interest rate.
6. The volatility of the underlying financial instrument.
7. 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 four 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.
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.
Volatility
Volatility is one of the
most important factors in an option's price. It measures the amount by which an
underlying asset is expected to fluctuate in a given period of time. It
significantly impacts the price of an option's premium and heavily contributes
to an option's time value. In basic terms, volatility can be viewed as the speed
of change in the market, although you may prefer to think of it as market
confusion. The more confused a market is, the better chance an option has of
ending up in-the-money. A stable market moves slowly. Volatility measures the
speed of change in the price of the underlying instrument or the option. The
higher the volatility, the more chance an option has of becoming profitable by
expiration. That's why volatility is a primary determinant in the valuation of
options' premiums. There are options strategies that can be used to take
advantage of either scenario.
Liquidity
Options strategies must be
applied in specific market conditions to be money-makers. Liquidity is one of
these market conditions. Liquidity is the ease with which a market can be
traded. A plentiful number of buyers and sellers boosts the volume of trading
producing a liquid market. Liquidity allows traders to get their orders filled
easily as well as to quickly exit a position.
The best way to discover which markets have liquidity is to actually visit an
exchange. The pits where you see absolute chaos are markets with liquidity. As
long as there are plenty of floor traders screaming and yelling out orders as if
their lives depended on it, you will probably have no problem getting in and out
of a trade. However, I tend to avoid the pits where the floor traders are
falling asleep as they read the newspapers. These are obviously illiquid markets
and it would not be a wise move to place an options-based trade there.
If you don't have the ability to actually visit an exchange, you can still check
out the liquidity of a market by reviewing the market's volume to see how many
shares have been bought and sold in one day. As a rule of thumb, I choose
markets that trade at least 300,000 shares a day, although one million shares a
day is even better. It is also vital to ascertain whether or not trading volume
is increasing or decreasing. This kind of volume movement is studied to indicate
turning points in market price action. You can also monitor liquidity by
monitoring the buying and selling of block trades-orders of 5,000 shares at a
time-by institutional traders.
LEAPs
Long-term Equity
Anticipation Products (LEAPS) are options that don't expire for at least 9
months and can have expiration 2 or 3 years out. Once an option's expiration
gets closer than 9 months, they become plain options again with an entirely new
ticker symbol. Be this as it may, LEAPS are in every way an option. Their
expirations are a long way off and that makes them prime candidates for
long-term plays and secure bets for shorter-term trades.
For traders with a traditional buy and hold orientation, options usually carry
with them the stigma of being short-term trading tools with tax consequences.
LEAPS, by the very nature of their long-term expiration dates, help to overcome
this stigma. It isn't unusual for LEAPS traders to hold a position for more than
a year. Plus, LEAPS have the added benefit of giving a trader significantly more
time to be right about a market move.
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