Factors Affecting Options Pricing That You Should Know

Options trading is a great way to generate consistent cash flow, whether it be by trading in stocks, ETFs, or indexes. With options, you can buy a stock today but hope to sell it at a higher price in the future for a profit. And that’s exactly what options are designed for.

They give investors the chance to purchase a fixed number of shares of stock at a fixed price on a specific date in the future. This feature of investing makes it possible to generate income with little up-front capital and little risk. 

However, trading options presents challenges that other forms of investing don’t. With that being said, understanding how different factors affect options pricing is essential if you plan on trading options successfully. Read on to learn about these factors and how they can impact your trades...

How to calculate options pricing

Every option’s price is dependent on a few key factors and the implied volatility of the options as a whole. For example, let’s say you have the option to buy 100 shares of ABC stock at Rs. 100/share on January 20. 

If the price of ABC is Rs.100 on that date, you’ll be able to purchase the shares at Rs. 100/share.

Now let’s say that on that date ABC’s share price rises to Rs. 110. You’ll be happy because you’ll make Rs. 10/share on that one option. 

However, if the share price drops back to Rs. 100, you’ll lose money. Because of this, you need to keep track of the current price of the share and the implied volatility of the options you’re considering trading. If the implied volatility is high, your option is likely to be worth less than the current price of the share. 

In order to calculate the price of your trade, you need to add the cost of the shares you’re buying with the cost of the shares you’re selling with the cost of the premium from the premiums collected from the premiums collected and subtract the gain or loss of the option.

What affects options pricing?

The factors that affect options pricing are the same factors that affect any other asset’s price. This includes supply and demand, the current stock’s performance, and the general market’s sentiment. 

However, there are a few factors that are unique to options trading and can have an impact on the price. 

These factors include the implied volatility of the option, the dividend yield of the underlying stock, and the number of active option contract open interest. 

Understanding the factors that affect options pricing can help you better estimate their value when trading. This can help you decide when to enter a trade, which contracts to enter, and when to exit a trade so you’re not left holding losing positions.

Market volatility and the delta

The market volatility of an option affects the price of that option. Although the implied volatility of an option affects its price, the market volatility of that option affects its price even more because it affects the delta of the option. 

The delta is a number that tells you the extent to which an option’s price may change. If a share price changes by Rs.1, the delta of that option tells you how much it may change. 

Higher market volatility will cause an option with a low delta to move around a lot. With a low delta, an option may not change much even if the price of the share changes by Rs.1.

Dividend yield and Existing Option Contracts

The dividend yield of a stock affects the price of the call option and the put option that are currently in existence. If there are currently no call or put options available in the market, the dividend yield of the underlying stock will have a greater impact on the price of the call option.

New Option Contracts

The amount of open interest in an option affects the price of that option. This is because open interest is a function of delta. If a certain amount of delta is exchanged hands, that option’s price is affected.

Wrapping It Up

Options trading is one of the best ways to make money in the stock market because it's based on speculation. Selling an option makes sense when you expect the market to remain flat or below the strike price (in the case of calls) or above the strike price (in case of put option).

The option seller faces unlimited risk but little chance of reward (to the extent of the premium received)

This means that your high-risk trades won't affect your overall portfolio value because those trades don't affect your overall holdings.