Basic properties of Options |
  
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Basic properties of Options |
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American |
An option that can be exercised at any time during the life of the option. |
European |
An option that can only be exercised at the end of the options life. |
Call Option |
An option to buy an asset (underlying) or security at a fixed strike price (exercise) by a certain date. |
Put Option |
An option to sell an asset (underlying) or security at a fixed strike price (exercise) by a certain date. |
There are six factors that affect the price of an option:
1.The current Asset Price.
2.The Strike Price.
3.The time to expiration.
4.The volatility of the stock price.
5.The risk-free interest rate.
6.The yield/dividends expected during the life of the option.
In the following sections it is shown what happens to the option price when one of these six parameters changes and the others are held constant.
Asset Price and Strike Price
The Asset Price is the underlying price of the asset or security.
The Strike Price is the price at which an option can be exercised. It is the price the option holder receives (for a put) or pays (for a call) if he exercises the option.
If a call option is not exercised in the future, the return from a call option is the amount that the asset price exceeds the strike price. Call options become more valuable as the asset price increases. As the strike price increases, the call value decreases. The opposite is true for a put option. The return from a put option is the amount by which the strike price exceeds the asset price. Put options become less valuable as the asset price increases and more valuable as the strike price increases.
Time to Expiration
The Expiration Time for all models is the actual number of Days or Years (depending on the TimeFormat flag) from the value date or present date until the options expiration date.
Both American call and put options become more valuable as the expiration time increases. For European options the result is not as straight forward. Call and put options do not necessarily become more valuable as the expiration time increases. This is due to the fact that the owner of a long-life European option does not have all of the exercise opportunities that an owner of a short-life European option does.
Volatility
The Volatility for all of the models is represented as a percentage and should be expressed in decimal form.
The volatility of an asset price, s, is defined so that sÖ(Dt) is the standard deviation of the return on the asset in a short length of time, Dt. It is a measure of the uncertainty of future stock movements. As the volatility increases, the likelihood that the asset will do very well or very poorly increases. These two outcomes offset each other for the owner of the asset. The value of both calls and puts increase as volatility increases. The call owner benefits from price increases but has limited downside risk if the price decreases because the most that the owner can lose is the price of the option. The put owner benefits from price decreases and has limited downside risk if the price increases.
Risk-Free Interest Rate
The Risk-Free Interest rate is the interest rate that may be obtained in the marketplace with virtually no risk (i.e. Treasury Bonds). All interest terms entered are assumed continuous unless otherwise specified. The interest rate format is specified in the InterestType term.
As interest rates increase, the expected growth rate of the asset price tends to increase. However, the present value of any future cash flows received by the owner of the option decreases. These two effects tend to decrease the value of a put option. Thus, put option prices decline as the risk-free interest rates increases. This does not hold true for the call. The effect of expected growth tends to dominate the present value effect. Thus, call option prices as the risk-free interest rate increases.
Yield / Dividends
The Yield Rate is the annualized percentage rate of return on the equity instrument. Discrete dividends can be converted to a continuous yield adjusting the Yield rate. All interest terms entered are assumed continuous unless otherwise specified. The yield rate format is specified in the YieldType term. Otherwise, the present values of all of the dividends are reduced from the Asset that is used for all of the models.
Dividends have the effect of reducing the asset price on the ex-dividend date. The call option value is negatively affected by any anticipated dividends, and the put option value is positively affected by any anticipated dividends.