Options derive their value from various factors, with the underlying asset’s price being the most influential. However, other elements like time, implied volatility, interest rates, and dividends also significantly impact option premiums. Understanding these factors helps traders make informed decisions and manage risk effectively.

Price and the Underlying Asset

Options are derivative securities, meaning their value comes from the underlying asset (e.g., stock or ETF). The relationship between the underlying asset's price and the option premium works as follows:

• Call options: Increase in value as the underlying stock price rises.
• Put options: Increase in value as the underlying stock price falls.

Non-Linear Relationship

The relationship between the stock price and option premium is not linear. For example:

• A $1 increase in the stock price might cause a $0.50 rise in the option premium at first.
• Another $1 increase might only raise the premium by $0.20.

Additionally, since options allow control of 100 shares per contract, premiums for higher-priced stocks are naturally more expensive than those for lower-priced stocks due to the increased value of the underlying.

<aside> 🤔 Example:

A call option for a $10 stock might cost $0.50 ($50 total for 1 contract).

A call option for a $500 stock could cost $20 ($2,000 total for 1 contract).

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Time and the Underlying Asset

Options are time-sensitive instruments, with their value tied to their expiration date. The time value represents the portion of the premium that traders are willing to pay for the potential of the option becoming profitable before it expires.

• Longer Expiration: Higher time value, as there is more potential for price movement.
• Shorter Expiration: Lower time value, as the window for profitable movement decreases.

Time Decay (Theta)