Mastering options trading basics includes understanding the factors that impact our option premiums. The original Black Scholes pricing model was designed to evaluate European Style options which can only be exercised on expiration Friday, not earlier. Here is a brief summary of the factors considered in these original pricing models:
Factors for original option pricing models
These four main factors have been detailed in my books, DVDs and many of my blog articles and videos. We must know and understand the concept of these pricing factors to become elite options traders. In today’s article I will discuss two additional factors that have been added to more recent option pricing models, interest rates and dividends. These factors apply more to American Style options, which can be exercised at any time from option purchase to 4PM ET on expiration Friday. The main significance interest rates and dividends have is on the possibility of early exercise of our American Style options.
Interest rates
As interest rates rise, the difference in the cost of a share of stock versus the cost of an option becomes more significant. A trader can buy an option instead of a stock and invest the unused cash to generate income from the higher interest rate. Therefore, the call buyer is willing to pay a higher price for the call option. Rising interest rates also make it more enticing to exercise a put early and use the cash generated from the sale of the underlying securities to benefit from the higher interest rates.
Dividends
Call buyers benefit from share appreciation and put buyers benefit from share depreciation. When a dividend is distributed (or more accurately, when the ex-dividend date approaches) the value of the underlying security drops in value by the amount of the dividend. This makes the value of the call option lower and the value of a put option higher as dividends rise. Early exercise of call premiums is more likely when the strike is in-the-money and the time value of the option premium is less than the dividend about to be distributed. Early exercise, when it occurs, usually takes place 1-2 days prior to the ex-dividend date.
Here is a summary of the minor factors found in the more recent option pricing models:
Factors included in recent option pricing models
Summary
There were four major factors included in the original option pricing models which were geared to European Style options. These were the stock price, the strike price, the expected volatility of the stock and the time to expiration. Newer pricing models now also include statistics for interest rates and dividends which apply to potential early exercise of American Style options.
Market tone
We had a mixed week of economic reports with the most significant one being the most positive:
- According to the Commerce Department, GDP (inflation-adjusted value of all goods and services produced in the US) grew at an annualized rate of 5% in the 3rd quarter. Both consumer and business spending contributed to this strong number
- The GDP stats from the 2nd and 3rd quarters represented the 1st time since 2003 that the economy grew by an annual rate > 4% for 2 consecutive quarters
- Sales of existing homes declined by 6.1% in November, the first drop in the past 3 months
- Sales of new homes fell by 1.6% in November below economist’s projections and the 2nd straight monthly decline
- The median price for new homes dropped to $280,900 from $290,100 in October
- Personal income rose by 0.4% in November, the highest level since June, mainly due to wages and dividend growth
- Personal spending ticked up by 0.6% above the 0.5% expected
- Durable goods orders fell by 0.7% in November, the 3rd decline in 4 months
- Initial jobless claims for the week ending December 20th came in at 280,000, below the 290,000 anticipated
For the week, the S&P 500 increased by 0.9% for a year-to-date return of 15%, including dividends.
Summary
IBD: Uptrend under pressure
GMI: 6/6- Buy signal since market close of December 19, 2014
BCI: Cautiously bullish due to the weakened housing news, selling equal numbers of in-the-money and out-of-the-money strikes. Selling out-of-the-money puts is another way to navigate markets of concern.
Happy New Year to one and all. Together, let’s make 2015 a great financial success,