Properties of Stock Options
Lesson 5
Factors Affecting Option Prices
There are six factors affecting the price of a stock option:
1. The current stock price, S0
2. The strike price, K
3. The time to expiration, T
4. The volatility of the stock price, σ
5. The risk-free interest rate, r
6. The dividends that are expected to be paid.
The current stock price, S0
- The value of all call options increases (decreases) as S0 increases (decreases).
- The value of the put decreases (increases) as S0 increases (decreases).
The Strike Price of the Option (K)
- For call options: the value decreases (increases) as the strike price (K) increases (decreases).
- For put options, the value increases (decreases) as the strike price (K) increases (decreases).
The time to expiration, T
With American-style options, as the time to expiration increases, the value of the option increases. With more time, there are
higher chances of the option moving in the money.
- As the time to expiration increases, the value of a call option increases.
- As the time to expiration increases, the value of a put option also increases.
However, the same does not apply to European-style options, precisely when the underlying has scheduled dividends. For
example, assume we have a two-month call option and a four-month call with the same exercise price K and the same underlying
stock. Assume further that a sizeable dividend is expected in three months. The ex-dividend stock price and call price will decrease.
As such, the two-month call could actually be more valuable than the four-month call.
The volatility of the stock price, σ
Volatility is considered the most significant factor in the valuation of options. As volatility increases, the
value of all options increases. Since the maximum loss for the buyer of a call or put option is limited to
the premium paid, we can conclude that there are higher chances of the option expiring in the money
as volatility increases.
- As volatility increases, the value of a call option increases.
- As volatility increases, the value of a put option increases.
The risk-free interest rate, r
Here, the simplest way to think about this is as a rate of return on a stock. Let’s say you have the choice
between buying a bond worth $1000 or one share of stock priced at $1000. If you know the risk-free
rate of interest is 5%, you would expect the stock price to increase by more than 5% on average.
Otherwise, why would you buy a share of stock instead of investing in a risk-free bond? Therefore,
- As the time the risk-free rate increases, the value of a call option increases.
- However, as the risk-free rate increases, the value of a put option decreases.
The dividends that are expected to be paid.
Payments from an underlying may include dividends. As we’ve seen previously,
immediately after payment of a dividend the stock price falls by the amount of the
dividend. However, the benefits of these cash flows to the holders of the underlying
security do not pass to the holder of a call option. Therefore-
- As dividends increase, the value of a call option decreases.
- However, as dividends increase, the value of a put option decreases.
Notation
C: American call option
c: European call option price
price
P: American put option
p: European put option price
price
ST: Stock price at option
S0: Stock price today maturity
K: Strike price D: PV of dividends paid
T: Life of option during life of option
s: Volatility of stock price r Risk-free rate for maturity
T with cont. comp.
Effect of Variables on Option Pricing
Put-Call parity
- Put-call parity states that the price of a call option implicitly informs a certain price
for the corresponding put option with the same strike and expiration and vice versa.
- In other words, put-call parity is the relationship between the price of a European
put option and the price of a European call option, with the same strike price and time
to maturity.
Consider the following two portfolios that were used in the previous section-
Portfolio A: A Call Option Plus a Put Option holding same underlying stock and same
expiration.
Portfolio B : A Forward contract of the same underlying asset of the same stock having
same expiration date which forward price is equal to the strike price of your option.
We continue to assume that the stock pays no dividends. The call and put options
have the same strike price K and the same time to maturity T.
Put-Call parity
Put Call Parity Formula: Example:
PV(x)+C = P+S
Here PV(x)= Present value of strike
price which is discounted
accordingly to the expiration date.
C= Price of Call Options
P= Price of Put Options
S= Current market price of the
underlying asset.
If there is a mismatch between the
price values on the above equation,
then an arbitrage opportunity arises.
Put-Call parity
Now, if the both situation are summarized, then we will find-
- Since the portfolios have identical values at time T, they must have identical values today.
- If this were not the case, an arbitrageur could buy the less expensive portfolio and sell the
more expensive one.
- Because the portfolios are guaranteed to cancel each other out at time T, this trading
strategy would lock in an arbitrage profit equal to the difference in the values of the two
portfolios.
The components of portfolio A are worth c and Ke-rT today, and the components of
portfolio C are worth p and S0 today. Hence-
c + Ke -rT =p + S0
Or PV(x)+C = P+S
This relationship is known as put–call parity. It shows that the value of a European call with a
certain exercise price and exercise date can be deduced from the value of a European put
with the same exercise price and exercise date, and vice versa.
Practice Math: 11.11, 11.14, 11.15
The End