Friday, 20 April 2012

How is Option Priced?

There are 6 factors that affect option's price.  Nevertheless, the impact of interest rate and dividend are often considered negligible as compared to the other factors.  Most of the time, for each level of strike price, an option's price will move due to the movement of underlying stock price, volatility and time.

The Black-Scholes formula can be used to calculate the theoretical value of an option based on the above factors.

Since option's buyers (long position) will profit when the option price rises after they buy (Buy Low, Sell High), whereas the seller (short position) will profit when the option price falls after they sell (Sell High, Buy Low), the impact of the above factors will also be different.  

The following table shows how the major factors (stock price, time to expiration, implied volatility) affect an option's position.

Increase in Implied Volatility (IV) would increase option's price (both calls & puts), assuming other factors unchanged.  Hence, this will be favorable for option buyers who will gain if the option price increases (buy low, sell high), but unfavorable for option sellers that will profit if the option price drops (sell high, buy low).

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