OPTIONS PRICING Prices of options are commonly depend upon six factors.

Unlike futures which derives there prices primarily from prices of the undertaking. Option's prices are far more complex. The table below helps understand the affect of each of these factors and gives a broad picture of option pricing keeping all other factors constant. The table presents the case of European as well as American Options. EFFECT OF INCREASE IN THE RELEVANT PARAMETRE ON OPTION PRICES

PARAMETERS Spot Price (S) Strike Price (Xt) Time to Expiration (T) Volatility () Risk Free Interest Rates (r) Dividends (D)

EUROPEAN OPTIONS AMERICAN OPTIONS Buying Buying CALL PUT CALL PUT

? Favourable Unfavourable

SPOT PRICES: In case of a call option the payoff for the buyer is max(S - Xt, 0) therefore, more the Spot Price more is the payoff and it is favourable for the buyer. It is the other way round for the seller, more the Spot Price higher are the chances of his going into a loss. In case of a put Option, the payoff for the buyer is max(Xt - S, 0) therefore, more the Spot Price more are the chances of going into a loss. It is the reverse for Put Writing. STRIKE PRICE: In case of a call option the payoff for the buyer is shown above. As per this relationship a higher strike price would reduce the profits for the holder of the call option. TIME TO EXPIRATION: More the time to Expiration more favourable is the option. This can only exist in case of American option as in case of European Options the Options Contract matures only on the Date of Maturity. VOLATILITY: More the volatility, higher is the probability of the option generating higher returns to the buyer. The downside in both the cases of call and put is fixed but the gains can be unlimited. If the price falls heavily in case of a call buyer then the maximum that he loses is the premium paid and nothing more than that. More so he/ she can buy the same shares form the spot market at a lower price. Similar is the case of the put option buyer. The table show all effects on the buyer side of the contract. RISK FREE RATE OF INTEREST: In reality the r and the stock market is inversely related. But theoretically speaking, when all other variables are fixed and interest rate increases this leads to a double effect: Increase in expected growth rate of stock prices Discounting factor increases making the price fall In case of a call option these effects work in the opposite direction. The first effect is positive as at a higher value in the future the call option would be exercised and would give a profit. The second affect is negative as is that of discounting. The first effect is far more dominant than the second one, and the overall effect is favourable on the call option. DIVIDENDS: When dividends are announced then the stock prices on ex-dividend are reduced. This is favourable for the put option and unfavourable for the call option.