Underlying stock price
Time to expiration
A call option carries the right to buy a stock at a certain price in the future; it is essentially a bet that the underlying stock price will go higher. A put option carries the right to sell a stock at a certain price in the future; it is essentially a bet that the underlying stock price will go lower. One might think that what makes the price of a call go up also makes the price of a put go down, and it usually does, but not always. Let’s take a look at how and why each component of DIVUTS affects the prices of puts and calls.
Although dividends are the first item on the list, they are in no way the most straightforward. People might be inclined to think that because a big dividend is better than a small dividend, a bigger dividend would make the price of the underlying stock, and thus the call, go up. The problem with that line of thinking is that the dividend is paid to the underlying shareholder, not to the holder of a call option. In fact, the price of the stock will be adjusted down on the day that the stock trades ex-dividend by the amount of the dividend.
So, the bigger the dividend, the bigger the adjustment. This adjustment, however, isn’t even noticed by most market participants because, generally speaking, the size of the quarterly dividend is small relative to the price of the stock; and other factors could be driving the whole market up or down that day. This is one of those “all other things being equal” situations.
In other words, if absolutely nothing else changes other than that the day to qualify to receive the next 20 cent dividend has passed, then the stock should be adjusted downward by 20 cents. The prices of all the options on the stock will also change accordingly, so calls will go down by the amount of the dividend and puts will go up. This phenomenon is not exactly intuitive, but it is easier to remember if we understand that the dividend goes to the owners of the stock and not the option holders. So, a bigger dividend makes calls go down and puts go up.
Interest rates have an impact on option prices that also may not be intuitive at first glance. A call option allows you to buy a stock at a predetermined price, or “strike price.” But you have that right for only a short period of time. The option “contract” has an expiration date, which is why the prices of options are much lower than the actual stock price.
The actual shares of stock don’t expire, but the options do. So, if I think the price of a stock is going to rise in the near term because of some catalyst, such as earnings being released or a new product being announced, I can spend a lot less money making that bet by buying call options on the stock rather than buying the stock itself. That means I get to leave the rest of the money in the bank earning interest.
This is the key to understanding how interest rates affect option prices. The higher the interest rate that I am earning on bank deposits, the more valuable the call option because I don’t have to lay out the whole price of the stock. It works the opposite way for puts. If I own shares of a stock that I think may be going down in the near term, I can sell the stock or I can buy puts. If I sell the stock, I will get to deposit the whole amount in the bank and earn higher interest rates. As rates go higher, the benefit of selling the underlying shares goes up and the value of protecting the position with options goes down; so, the price of the puts goes down. Higher rates make calls go up and puts go down.
There is a set of variables that option traders often refer to as “the Greeks,” and the Greek notation for a change in the option price relative to a change in interest rates is “rho.” Think “R” for rates.
Think of volatility as “how much.” Stocks go up and down. Volatility is how much they go up and down on average.
If a stock is at $100 and has a volatility of 20%, that means it will probably be between $80 and $120 (up 20% or down 20%) over the next year if everything stays normal. If the same stock has a 40% volatility, it will be between $60 and $140 over the next year. Another way of saying this is that we don’t know which way a stock will go for sure, but we can measure how much it has moved in the past and extrapolate.
So, the higher the volatility, the wider the potential range of outcomes. In essence, the uncertainty is going up. It could go up more or down more. That means that all option prices will be higher — for both puts and calls. This is one of the instances in which puts and calls move in the same direction: Higher volatility makes both calls and puts go up. The Greek notation for a change in the option price relative to a change in volatility is “vega.” Think “V” for volatility.
Underlying Stock Price
The underlying stock price is the most straightforward of all the items. If the underlying stock price goes up, buying the stock at the predetermined price becomes more attractive and the price of the call goes up. Conversely, the price of the put goes down.
The Greek notation for a change in the option price relative to a change in the underlying stock price is “delta.” The “D” in delta doesn’t really stand for an English word, but delta means “change in.” Incidentally, the amount by which the delta changes for each dollar change in the underlying stock (the change of the change, if you will) is known as “gamma.”
Time to Expiration
This concept of time to expiration is also pretty straightforward: The more time you have until the rights of the contract are no longer valid, the more valuable the contract. It works the same way for both puts and calls. So, longer time to expiration makes both puts and calls go up. The Greek notation for a change in the option price relative to a change in time to expiry is “theta.” Think “T” for time.
The strike price is the price at which the option contract will be executed. For a person who owns a call, it is the price at which he has the right to purchase the underlying stock. For the owner of a put, it is the price she will receive should she choose to exercise the rights to the contract and sell the underlying stock. Strike prices don’t change, but the price of the underlying stock does.
So, what is meant here is really the price of the stock relative to the individual strike prices. In plain English, for a stock that is at $100, the right to buy it at $20 would have $75 more value than the right to buy it at $95. Said another way, the lower the strike price of a call, the higher the value of that call. This works the opposite way for put contracts. If a stock is at $100, the right to sell it at $95 would have $75 more value than the right to sell it at $20. Said another way, the lower the strike price of a put, the lower the value of that put. So, lower strike prices make calls go up and puts go down. Like dividends, there is no specific Greek notation for this concept, although it is related to the delta and gamma notations.
If you have more questions about options or anything else, Tweet me @SconsetCapital or ask them in the comments below.