Option Pricing Determinants – Spot Price, Strike Price, Time, Volatility
1. Introduction
Why is the premium for a Call Option ₹100 today and ₹120 tomorrow? The price (Premium) depends on 5 key factors.
2. The 5 Determinants
A. Spot Price of Underlying (S)
- Call: If Spot Price rises, Call Premium Rises. (Closer to profit).
- Put: If Spot Price rises, Put Premium Falls. (Further from profit).
B. Strike Price (X)
- Call: Higher Strike Price = Lower Premium. (Harder to reach).
- Put: Higher Strike Price = Higher Premium. (Easier to sell high).
C. Time to Expiry (t)
- Logic: More time means more chance for things to happen.
- Impact: Longer time = Higher Premium for both Call and Put.
- Note: As expiry nears, premium erodes (Time Decay).
D. Volatility (σ / Sigma)
- Logic: High volatility means wild swings (high chance of huge profit).
- Impact: Higher Volatility = Higher Premium for both Call and Put.
- Note: This is the most crucial factor.
E. Risk-Free Interest Rate (r)
- Impact: Higher rates slightly increase Call premiums and decrease Put premiums.
3. Summary Table
| Factor | Effect on Call Premium | Effect on Put Premium |
|---|---|---|
| Spot Price (Increase) | Increases ⬆️ | Decreases ⬇️ |
| Strike Price (Increase) | Decreases ⬇️ | Increases ⬆️ |
| Time (Increase) | Increases ⬆️ | Increases ⬆️ |
| Volatility (Increase) | Increases ⬆️ | Increases ⬆️ |
4. Exam Notes: Writing the Answer
Question: "Discuss the factors affecting Option Premium." (10 Marks)
Answering Structure:
- List: Bullet point the 5 factors (S, X, T, Sigma, r).
- Explain: For each, write one line on "Why" and one line on "Direction" (Increases/Decreases).
- Highlight: Mention that Volatility is unique to options (doesn't affect Forwards much).
5. Quiz Time! 🎯
Loading quiz…