WHAT TRULY DRIVES OPTION PRICES?

Understanding Option Pricing Components

Options are sophisticated financial instruments, offering traders and investors the ability to speculate, hedge, or manage risk. To properly navigate the options market, it is crucial to comprehend what drives option prices. The value of an option is not arbitrary; rather, it is determined by several interrelated components that affect its premium.

These components largely fall into two categories: intrinsic value and extrinsic value. Intrinsic value represents the difference between the strike price and the underlying asset's market price, applicable only if the option is in-the-money. Extrinsic value, also known as time value, encompasses all other factors that influence option pricing, including the time to expiration, implied volatility, interest rates, and expected dividends.

In this guide, we delve into the five central dynamics that impact option prices:

• Underlying asset price
• Implied volatility
• Time until expiration
• Interest rates
• Expected dividends

Each of these factors plays a distinct role in determining both call and put option premiums. By understanding these elements, traders can make more informed decisions and adopt strategies with greater precision.

The Role of the Underlying Asset

The foundation of any option is its underlying asset. The price of the underlying security—be it a stock, index, commodity, or currency—is the most direct and observable driver of an option's value.

For call options, the option's value tends to increase as the price of the underlying asset goes up, since the buyer gains the right to purchase the asset at a predetermined strike price which becomes more advantageous.

Conversely, put options benefit from a declining underlying price. A lower asset price increases the put's intrinsic value as the holder gains the right to sell the asset at a higher fixed strike price.

Key takeaways on the relationship with the underlying:

• Options are derivatives—they derive their value directly from the price of the underlying asset.
• Any fluctuation in the underlying asset immediately affects the intrinsic value of an in-the-money option.
• Even for out-of-the-money options, underlying price changes affect the probability of expiring in-the-money, thus altering the option premium.

The sensitivity of an option’s price to changes in the underlying is measured by delta. For instance, a delta of 0.5 implies that for every £1 move in the underlying, the option's price will theoretically move by £0.50.

While the underlying asset is the most intuitive element, its interaction with time, volatility, and other variables complicates option pricing. That said, watching the underlying's price should always be a first step in understanding an option's movement.

Moreover, keep in mind that in highly volatile markets, a surge in the underlying's movement could indirectly alter implied volatility levels, adding a second layer of complexity in how options are priced.

Implied Volatility, Time, and Interest Rates

Beyond the underlying price, three central components—implied volatility (IV), time to expiration, and interest rates—significantly shape option prices. These influence what’s known as the option’s extrinsic value.

Implied Volatility (IV)

Implied volatility reflects the market's expectation of future volatility in the price of the underlying asset. It represents the annualised projected percentage movement in price and is derived from the market price of options using models such as Black-Scholes or binomial pricing models.

Higher implied volatility leads to more expensive options because greater volatility increases the likelihood of the option expiring in-the-money. Option traders closely monitor IV, particularly during earnings announcements or geopolitical events, when anticipated volatility spikes.

• IV is not historical; it predicts future potential price swings.
• A change in IV can significantly impact an option’s value, especially for at-the-money contracts.
• Volatility skew and term structure influence how IV is distributed across different strikes and expirations.

Time to Expiration

Time plays a critical role in option valuation. All else being equal, the more time an option has until expiry, the greater its value. This is because a longer duration offers more opportunity for the underlying price to move in favour of the holder.

This time-based value, called theta, erodes as expiration approaches. Known as time decay, theta increases in intensity during the final 30 days of the option’s life, accelerating the decline in value for options that remain out-of-the-money.

While time decay harms holders of options, it benefits sellers who receive premiums and profit if options expire worthless.

Interest Rates

Interest rates, particularly the risk-free rate (e.g., yield on government bonds), may have a subtle yet systematic effect on option prices. An increase in interest rates generally raises call premiums and decreases put premiums.

This is primarily due to the concept of opportunity cost. With a higher rate, holding cash becomes more attractive, elevating call values. Also, as call options postpone payment for the underlying asset, rising rates increase their theoretical value.

• High rates increase call option value due to deferred payment benefits.
• Put options decline slightly in value because locking into a future sell price becomes less advantageous.
• The impact of rates is more pronounced for longer-duration options such as LEAPS (Long-term Equity Anticipation Securities).

While interest rates may not fluctuate frequently in the short term, they remain integrated into most pricing models, ensuring theoretical accuracy in valuation.