Lesson 4: Elements that affect the Premium
It continues the course for Beginners on Options. In the previous article I have compared options and stocks, now let's see what are the elements that affect the value of the premium.
1. Strike. The strike and price of the underlying affect the premium that the market will require us when we buy an option. In figure 4 below you find on the right the strike and on the left the corresponding premium of the CALL options on Apple with expiration December 15, 2017.
You can see that, at the changing of the strike, also the required premium changes and this because they differ on the chances that Yahoo has to reach a particular strike. It will surely be more likely that Apple, that has a value of $ 174.00, will arrive at $ 180.00 rather than $ 190.00 or $ 200.00.
As a rule, the value of the option increases as the strike is close to the current price. means that if the underlying rises, the strikes that react most importantly, the strikes are more responsive, they are the ones closest to the current price.
It happens because more the strike moves away from the present price and lower are the chances that the underlying reaches that strike and therefore, the lower is the premium that will be required by the market. The strike can be of three types:
CALL options:
- ITM: the price of the underlying is more than the strike price.
- ATM: the price of the underlying is the same as the strike price.
- OTM: the price of the underlying is less than the strike price.
PUT options:
- ITM: the price of the underlying is less than the strike price.
- ATM: the price of the underlying is the same as the strike price.
- OTM: the price of the underlying is more than the strike price.
2. Expiration. Depending on the expiry date that we will select, this will affect the premium that the market will ask us for that option. In the figure below you find on the right the premium and on left the different expirations of the CALL option on Apple, strike $ 180.00.
Further away is the expiration date, the greater is the time limit for Apple to arrive at a particular strike, and more the premium increases.
This is because for Apple is much more likely to drop from $ 174,00 to $ 160.00 for example, in three months than in only one and, for this reason, the market will ask us a higher premium for buy the PUT option.
As a rule, it more increases the expiration of an option, and higher is the premium of the option, CALL or PUT.
3. Dividend. The dividend also determinants of an option’s price. Obviously, if the stock or the ETF pays no dividend, or if we are working with a future or a commodity, the question of a dividend makes no difference. A dividend will lower the value of a call option. Therefore, stocks with high dividends will have low call option premiums.
4. Volatility. Volatility is the most elementary element that affects an option and represents the price change of an underlying (stock, index, commodity, etc.) over a given time interval. The more the volatility is high, the more the value of the option increases.
In next article, we will see better the volatility.
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