qualitative analysis

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factors that influence option values

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  • 1. As indicated, theunderlying price and strike price determinethe intrinsic value; the time until expiration andvolatility determine the probability of aprofitable move; the interest rates determinethe cost of money; anddividends can cause anadjustment to shareprice.There are six primaryfactors that influence optionprices:

2. The most influentialfactoronanoptionpremium is the currentIf Call prices Put pricesmarketprice of underlyingwill ...will ...prices ...the underlying asset. Ingeneral, as the price of theunderlying increases, callprices increase and put IncreaseIncrease Decreaseprices decrease.Conversely, as the price ofthe underlying decreases,DecreaseDecreaseIncreasecall prices decrease andput prices increase. 3. Volatility is the degree to which price moves,regardless of direction. It is a measure of the speed andmagnitude of the underlyings price changes. Historicalvolatility refers to the actual price changes that have beenobserved over a specified time period. Option traders canevaluate historical volatility to determine possiblevolatility in the future. Implied volatility, on the otherhand, is a forecast of future volatility and acts as anindicator of the current market sentiment. While impliedvolatility is often difficult to quantify, option premiumswill generally be higher if the underlying exhibits highervolatility, because it will have higher expected pricefluctuations. The greater the expected volatility, the higher the optionvalue 4. The strike price determines if the option hasany intrinsic value. Remember, intrinsic value isthe difference between the strike price of theoption and the current price of the underlying.The premium typically increases as the optionbecomes further in-the-money (where the strikeprice becomes more favorable in relation to thecurrent underlying price). The premium generallydecreases as the option becomes more out-of-the-money (when the strike price is lessfavorable in relation to the underlying).Premiums increase as options become further in-the-money 5. The longer an option has until expiration, thegreater the chance that it will end up in-the-money, orprofitable. As expiration approaches, the options timevalue decreases. In general, an option loses one-third ofits time value during the first half of its life and two-thirds of its value during the second half. The underlyingsvolatility is a factor in time value; if the underlying ishighly volatile, one could reasonably expect a greaterdegree of price movement before expiration. Theopposite holds true where the underlying typicallyexhibits low volatility; the time value will be lower if theunderlying price is not expected to move much.The longer the time until expiration, thehigher the option priceThe shorter the time until expiration, the lower the option price 6. Interest ratesanddividends also have small, butmeasurable, effects on optionIf interest Call prices Put pricesprices. In general, as interest rates ...will ... will ...rates rise, call premiums willincrease and put premiums willdecrease. This is because of theRiseIncrease Decreasecosts associated with owning theunderlying; the purchase will Fall DecreaseIncreaseincur either interest expense (ifthe money is borrowed) or lostinterest income (if existing fundsDividends canaffectare used to purchase the option pricesbecause theshares). In either case, the buyer underlying stocks price typicallywill have interest costs. drops by the amount of any cash dividend on the ex-dividend date. IfAs a result, if the underlyingsCall prices Put prices dividend increases, call prices willdividendswill ... will ...decrease and put prices will... increase. Conversely,iftheRiseDecreaseIncrease underlyings dividend decreases, call prices will increase and putFall IncreaseDecreaseprices will decrease.

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