InvestorQ : What are the factors that go into determining the value of an option (premium)?
Bhavik Nehru made post

What are the factors that go into determining the value of an option (premium)?

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Bhavik Nehru answered.
2 years ago

How do you determine if the option is underpriced or if it is overpriced? Like in the case of equities, you can determine the fair value of an option using the Black & Scholes model. We shall not get the nuances of the black and Scholes model but this model basically looks at the various factors that determine the value of an option. Here are some of the key factors.

Underlying stock price is a key factor. For a call option, an increase in stock price is positive for the value of call options but negative for the value of put options.

Strike price or the exercise price of the option is the second factor. As the strike price of the option increases, it is negative for the value call but it is positive for the value of a put.

The most important and impactful factor is the volatility of the underlying stock. Volatility is positive for both call options and put options. That is because when the volatility goes up the probability of price movement goes up. But the movement can happen both ways. On the downside anyways, your risk is limited by the option premium paid. That is why higher volatility means higher value of both call and put options.

Greater the time to expiration greater is the chance of your option being profitable. Hence time to expiry favours both call and put options positively.

The risk free interest rate is also important because it is the rate at which the strike price gets discounted. If the rate increases then the present value of the strike price is lower and that would result in higher value for call option and lower value for put option.

In addition, there are also other intangible factors that play a role in determining the price of the option. Market participants" varying estimates of the underlying asset's future volatility has a role to play in option valuations. Even Individuals’ varying estimates of future performance of the underlying asset, based on fundamental or technical analysis can impact the option value. At a more basic level, the effect of supply and demand, both in the options marketplace and in the market for the underlying asset has an impact. Lastly, the "depth" of the market for that option - the number of transactions and the contract's trading volume on any given day also impacts the value of the option.