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Factors affecting Options pricing.

There and many factors which affects pricing of options, some of them are:

The Intrinsic Value of an Option: The intrinsic value of an option is defined as the amount by which an option is in-the-money or the immediate exercise value of the option when the underlying position is marked-to-market.

For a call option: Intrinsic value = Spot Price - Strike Price

For a put option: Intrinsic Value = Strike Price - Spot Price

The intrinsic value of an option must be positive or zero. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.

Price of underlying: The premium is affected by the price movements in the underlying instrument. For call options - the right to buy the nderlying at a fixed strike price - as the underlying price rises so does its premium. As the underlying price falls so does the cost of the option premium. For put options - the right to sell the underlying at a fixed strike price - as the underlying price rises, the premium falls; as the underlying price falls the premium cost rises.

The Time Value of an Option: Generally, the longer the time remaining until an options expiration, the higher its premium will be. This is because the longer an options lifetime, greater is the possibility that the underlying share price might move so as to make the option in-the-money. All other factors affecting an options price remaining the same, the time value portion of an options premium will decrease with the passage of time.

Note: This time decay increases rapidly in the last several weeks of an options life. When an option expires in-the-money, it is generally worth only its intrinsic value.

Volatility: Volatility is the tendency of the underlying securities market price to fluctuate either up or down. It reflects a price change magnitude; it does not imply a bias toward price movement in one direction or the other. Thus, it is a major factor in determining an options premium. The higher the volatility of the underlying stock, the higher the premium because there is a greater possibility that the option will move in-the-money. Generally, as the volatility of an underlying stock increases, the premiums of both calls and puts overlying at the stock increase, and vice versa.

Higher volatility = Higher premium

Lower volatility = Lover premium

Interest rates: In general interest rates have the least influence on options and equate approximately to the cost of carry of a futures contract. If the size of the options contract is vary large, then this factor may take on some importance. All other factors being equal as interest rates rise, premium costs fall and vice versa. The relationship can be thought of as and opportunity cost. In order to buy and option, the buyer must either borrow funds or use funds on deposit. then the premium costs fall. why should the buyer be compensated? Because the option writer receiving the premium, can place the funds on deposit and receive more interest than was previously anticipated. The situation is reversed when interest rates fall - premiums rise. This time it is the writer who needs to be compensated.

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