Factors affecting Stock Options
There are a number of factors that affect stock options but the following six are the most important.
- Current stock price
- Strike price
- Time to expiration
- Volatility of the underlying stock
- Interest rate; and
- Expected dividends during the life of the option
All of these factors influence the stock option price in different ways, and thus pricing or valuation of a stock option requires understanding of these factors and their impact. But understanding the impact of all of these factors acting at once is a bit complicated to grasp when we try to learn this subject the first few times. It is easier to first understand the impact of each of these factors (or variables), while keeping other factors constant and then continue to build our understanding of the impact of all of these factors acting at once. This is also the approach that many academic text books on Derivatives take when they explain this concept. We shall do the same in this article and in future, in a separate article dealing with Pricing and Valuation, we shall discuss how to integrate the impact of all of these acting at once.
Impact of each of the above factor affecting stock price, while other factors remain constant
A call option is in-the-money (ITM) when the the underlying stock price is more than the strike price. Therefore, if the underlying stock price increases, the call option would become more valuable, and if the underlying stock price decreases then the option becomes less valuable.
A put option is in-the-money (OTM) when the underlying stock price is less than the strike price. Therefore, if the underlying stock price decreases, the put option would become more valuable and if it increases then it becomes less valuable.
The following diagram shows this graphically.
For a call option, if the strike price is high then the underlying stock price has to move quite a lot for the option to be in-the-money (ITM). Therefore, if the strike price goes up then the call option becomes less valuable, and if the strike price comes down then the call option becomes more valuable.
A put option is in-the-money (ITM) when the strike price is high in comparision to the underlying stock price. If the strike price goes up then the option is more in the money or more valuable, and if the strike price comes down then the put option becomes less valuable.
Time to Expiration
If the time to expiration is more then the stock price has a chance to move up or down. If it moves up then the call option becomes more valuable and if moves down then the put option becomes more valuable. However, there is a slight difference between how the American and European options behave. Both of these type of options will become more valuable as the time to expiration increases. But in case of European options, there is a difference between how the call and put options behave. An European option can only be exercised on expiry. Dividends will decrease the stock price to the extent of dividend declaration. If there are two call options - one with a longer time to maturity (say 1 year) and the other a shorter time to maturity (say 6 months) - and a dividend is expected in 9 months time, then it is possible that the short call option will be more valuable than the longer call option.
Another difference is with regard to how the call and put options move vis-a-vis the time to maturity, irrespective of whether they are American or European options. As discussed above, we know that both call and put options will be more valuable if the time of expiration is more. However, the value of the call options have a chance to move up infinitely as the stock prices can move up infinitely (at least theoretically) within the time to expiration. But the put options cannot move up infinitely as the stock price cannot go below zero. Therefore, they look difference when plotted on graph, as shown below.
Volatiity is a measure of how the stock price will fluctuate over a period of time. Options are more valuable when there is volatility. If there is no volatility then there may not be any need to buy an option in the first place. Both calls and puts tend to gain from volatility. If the stock price increases, calls will become more valuable, and if the stock price decreases puts will become more valuable.
Interest rates affect the option value in different ways. If interest rates increase then investors would demand a higher rate of return from stocks. But at the same time the present value of the future cash flows decrease as we use a higher interest rate for discounting. In general, increase in interest rates will make the existing call options more valuable and put options less valuable. Similarly, decrease in interest rates will make the existing call options less valuable and put options more valuable.
In general, dividends reduce the stock price to the extent of dividend declared on the ex-dividend date. This is bad for call option buyers and good for put option buyers.
The impact of all the above factors is shown in the graph below. Note that these graphs represent the impact of each of the factor while keeping all other factors constant. This is not how the factors impact option prices in real but this is a starting point to understand the properties of stock options and the complexities involved in option pricing and valuation.
END OF MY NOTES