Introduction
Buyers and sellers in the stock market can agree to exchange securities at a set price. A call option is a contractual agreement between the buyer and the seller to exchange stocks at a set price and time. The contract gives the buyer a right and not an obligation to buy the agreed number of securities from the option seller. The stock price affects the value of the call option price. The prices are directly proportional, and an increase in stock price leads to an increase in the call option price. Time until expiration has an effect on the call and puts options, varying their value. Meanwhile, the risk-free rate and call options are directly proportional. The standard deviation of stock return is directly related to the call options price. The value of a call option varies depending on the intervening components in the stock market.
Call Options Price
Option buyers have the right to buy or sell securities at a predetermined price before a specific day. The options contract helps in determining the terms of the selling and buying of the securities (Ji et al., 2021). While the call options buyers need a rise in the underlying stock price, the put option buyers depend on the fall of the price. Other factors influencing the profitability of the call options contract are time expiration, risk-free rate, and the standard deviation of the stock returns. Therefore, the profitability of the call options contract is dynamic, being affected by various factors in the stock market.
Stock Price Effect on Call Option Price
The price of a given company’s share is determined by its profitability and stability in business. Consequently, different companies exhibit varying prices for their stocks. A share, stock, price is the highest amount of money an investor is willing to pay for a stock (Sari, 2021). Alternatively, the stock price can be described as the lowest amount of money a share can be bought for (Cao et al., 2022). The stock prices have a direct relationship with the call option prices. An increase in the value of stock prices leads to a consequent increase in the call option prices (Sari, 2021). Meanwhile, as the stock prices go down, the prices of call option fall (Yun et al., 2021). Although the effect of stock prices on call options is direct, it is not equal. Therefore, an increase in stock prices will likely lead to an increase but not equal call option price.
Time Expiration Effect on Call Option Price
The call option contracts have a specific duration before which the buyer can exercise their purchasing rights. Time expiration is directly affected by a stock’s time value, affecting the call option’s premium (Options Industry Council, 2020). The time value of a call option is any price above the intrinsic value before expiration. The amount helps in determining the profitability of a call option before expiration due to the overarching factors in the financial market. The time value increases with the duration available for the market conditions to benefit investors. Therefore, as the expiration time approaches the option’s time value erodes. The further the time expiration the higher the call option price in a stock market.
Risk-Free Rate Effect on Call Option Price
Investors purchase stock with an expectation of a positive change in the shares’ value. The risk-free rate is a theoretical rate of a return on investment without any risk (Xu et al., 2021). In reality, the rate does not exist since every investment is associated with specific risk, affecting the returns. The inflation rate from the Treasury bond yield and investment duration directly affects the risk-free rate (Xu et al., 2021). The risk-free rate is used in call option pricing since it helps determine an investment’s profitability. High risk-free rates are likely to lead to a rise in stock prices due to high returns on investment (Options Industry Council, 2020). Therefore, as risk-free rates increase the call option value and premium, increase.
Standard Deviation of Stock Returns Effect on Call Option Price
Stock prices are negatively affected by the risk of their associated assets. Consequently, investors are often unwilling to invest in assets that possess risk, and consequent low return on their investments. The standard deviation of a stock return helps in determining the risks of an asset (Yun et al., 2021). Investors in the financial market utilize the standard deviation in measuring the risks of assets to make a profitable purchase. The measurement involves market volatility, determining how widely stock prices are dispersed from the average price. For instance, if a $100 stock is trading with a 10% implied volatility, the standard deviation ranges between $90 and $110 for one standard deviation. Meanwhile, the deviation ranges between $80 and $120 for two standard deviations. An increase in standard deviation leads to an increase in the stock value that is directly proportional to the call option price. Therefore, an increase in standard deviation leads to an increase in the call option prices.
Conclusion
A call option is a contractual agreement between a buyer and seller in the financial market to purchase securities at a specific premium before time expiration. The call option prices are affected by the time expiration, risk-free rates, stock prices, and the standard deviation of the returns. An increase in the stock prices leads to an increase in the call option prices. Increasing risk-free rates causes an increase in the value of call options. Meanwhile, the is directly proportional to the call option premium due to fewer risks. Investors must consider all the variables affecting the call option prices before making any purchase or sale.
References
Cao, J., Goyal, A., Zhan, X., & Zhang, W. E. (2022). Unlocking ESG premium from options. Web.
Ji, X., Wang, J., & Yan, Z. (2021). A stock price prediction method based on deep learning technology. International Journal of Crowd Science, 5(1), pp. 55-72. Web.
Options Industry Council. (2020). Options Pricing. Web.
Sari, R. (2021). Analysis of the effect of earnings per share, price-earnings ratio and price to book value on the stock prices of state-owned enterprises. Golden Ratio of Finance Management, 1(1), pp. 25–32. Web.
Xu, Y., Kong, Y., & Lin, J. (2021). Stock-bond yield correlation analysis based on natural language processing. IEEE Xplore. Web.
Yun, K. K., Yoon, S. W., & Won, D. (2021). Prediction of stock price direction using a hybrid GA-XGBoost algorithm with a three-stage feature engineering process. Expert Systems with Applications, 186, pp. 115716. Web.