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Factors that affect the value of a stock options contract
There are basically six factors that affect the value of an options contract −
- The value of the underlying asset
- Exercise price
- Expiration time
- Risk-free rate of interest
- Payments on the underlying and cost to carry on
Let us take a look at each of these factors in detail.
The Value of the Underlying Asset
The value of the underlying assets has a significant effect on the value of an options contract. In fact, call options can be considered as buying the underlying, while put options can be viewed as selling the underlying. Therefore, when the value of underlying goes up, the value of the call option increases. Similarly, when the value of underlying goes down, the value of the put options increases.
The value of the call option goes up with a lower exercise price. This is so because when the exercise price goes down, one can buy more underlying assets. The opposite is applicable to put options. The higher the price of the exercise price, the higher will be the ability to buy put options. Therefore, the exercise price plays a role as the determinant for the value of the options.
The more the time of expiration, the more will be the value of the option. It is so, because the underlying assets get more time for movement when the expiry date is longer and so the option will have a higher value. The same logic is applicable even to put option. The value of the put option will go up with a longer expiry date.
There are however some exceptions to this rule with European options. When the risk-free rate is high, the volatility is lower which lets the European option go deep in the money and this can lead to a lower value of an option with an increasing expiration date.
Risk-free Rate of Interest
The value of an option is related to the risk-free rate of interest as the increase in the rate of return is higher with a higher return in the case of call options. The opposite is true for put options. With the decreasing interest rate, the value of the put option goes up. This happens due to the put-call parity of options.
Volatility increases the value of options both upside and downside. When the volatility is on the upside, the value of call options increases; while when the volatility is towards the downside, it increases the value of put options. It happens because the price of the underlying goes up with upside volatility and the value of the same goes down with downside volatility.
Payments on the underlying and cost to carry on
As a rule of thumb, the call option is equivalent to the long position of the underlying, while the put option is equivalent to the short position of the underlying. Therefore, the value of underlying decreases with the increase in benefits, and the value of options increases with an increase in cost to carry.
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