Options premiums are extremely popular among investors. This is because they play a huge role in improving various stock market strategies. Whether a stock rises or plummets, options premium gives you the chance to either make more profits if it rises or limit your losses if it plummets. It is a great way to protect yourself against the market’s unpredictable behavior because it gives you the option to buy and sell at a certain price for a specific period of time. The premium is the price that you pay for this option. In order to be able to take advantage of what stock options have to offer, keep reading to understand what factors affect the price of options premium.
Intrinsic value has a huge impact on an option’s premium price. The intrinsic value is basically the difference between a premium option’s market price and the exercise price. If you are opting for a call and the exercise price is less than the market price then the option will have intrinsic value. However, if you are going to opt for a put and the exercise price is more than the market price then the option will have intrinsic value. The intrinsic value of an option is usually incorporated in its premium provided its contract has intrinsic value. On the other hand, if it doesn’t then its premium will mainly depend on its time value. It is essential that you learn the intrinsic value of an option as it will give you an idea of the profits that you will stand to make if you are planning to use the option right away.
2. Time Value
The more time passes, the cheaper an option premium gets so its time value is basically determined by how much time is left on the contract before it expires. Usually, as the contract nears its end, it leaves little to no time for the value of the underlying asset to shift. On the other hand, when there is more time left on the contract, this gives the underlying asset’s value the chance to change. That said, the farther the stock options are from their end, the higher their premiums will be. However, you shouldn’t wait until your contract nears its expiration date to start exercising it, because when a contract nears its end, its time value drops more rapidly. Simply put, a stock option’s time value doesn’t decrease linearly but exponentially.
If you are new to the world of the stock exchange then understanding the concept of volatility and its role in an option’s price may be hard to grasp. Volatility mainly depends on observing the previous movements in a stock’s price over a certain period of time. In other words, it is learning about the daily record of stock prices. As a trader, you are required to know the future behavior of the stock. However, an options trader can’t know for sure what will happen with a stock. Therefore, they will need to guess it by learning about its history. They can do this by learning the option price, interest rates, time value, and dividends. You can gather this information by conducting online research. Once you get all of the information you need, you will only require one number which is the future volatility, and you can easily estimate it from all the information that you have gathered.
This process is called implied volatility because it helps traders to guess the future volatility. Implied volatility is used to calculate the options prices to determine if they are expensive or cheap. Have you ever heard a trader say that the premium levels are low or high but you weren’t sure what they were talking about? Well, what they are talking about here is the current implied volatility which is either low or high. When the trader can figure out the levels of the implied volatility they can decide whether the premiums are expensive so they can sell the options or they are cheap so they should buy them.
4. Interest Rates and Dividends
Interest rates are only considered influential factors if you are trading large options. Interest rates usually impact the funds’ prices. Basically, if the interest rates increase, the premium drops. On the other hand, the announcement of dividends can affect the option’s value. This is because the prices of the options are modified on non-dividend days when 10% or more dividends are announced. The premium decreases with higher dividends and increases with lesser ones.
There is no denying that understanding options can be complicated. However, once you have a full grasp of the factors mentioned here, you can understand how their pricing works. Understanding the basics of options will help you assess the risk and reward of every stock you buy or sell. You will also find many books online and offline that will help explain stock options in detail to help you become a successful options trader.