What influences the price of an option?

Five main factors may influence the price of an option, also called the premium: 

• The strike price of the option
• The market price of the underlying asset
• Volatility, the price uncertainty of the underlying asset
• Remaining life (the time length until the expiry date)
• The interest of a loan with a term similar to the option’s remaining life 

If there are payments attached to the underlying asset during the life of the contract, e.g. share dividend, the expected size and time of payment will also have an impact on pricing. 

The strike price of an option

The price of an option is naturally related to the strike price. A lower strike price implies that the buyer of a call option is willing to pay more to acquire the option. Similarly, a higher strike price will cause the price of a put option to rise since the buyer of the right to sell the underlying shares may sell at a higher price. 

The price of the underlying asset

The option price depends on the market price of the underlying asset. If the price of the underlying asset increases, the premium of a call option will rise and the premium of a put option will fall. If the price of the underlying asset drops, the premium of a put option will rise and the premium of a call option will fall. 

Volatility

Volatility expresses the expectations to fluctuations in the price of the underlying asset. The volatility has an influence on the value of an option because it is one of the factors that determine the probability to what extent the option will end in the money, and thus the size of payoff at expiry; The higher the volatility, the higher the value of the option price. The option price will therefore rise if the volatility of the underlying asset’s market price increases. 

Interest rates

Buying a call option may be considered as an alternative to buying the underlying asset. The purchase of a call option postpones the investment until the option’s expiry date, and the excess liquidity can be placed on the money market. For that reason the seller of a call option will naturally demand payment for having to finance the underlying asset during the life of the option. A higher interest rate will therefore imply a higher price on call options. The same applies to put options, the price of which will accordingly drop as interest rates go up. The interest rate level of both call and put options is, however, quite low.