Option Prices: The Role of Interest Rates and Dividends

01/05/2015 8:00 am EST

Focus: OPTIONS

Alan Ellman

President, The Blue Collar Investor Corp.

Alan Ellman, of TheBlueCollarInvestor.com, discusses the role of interest rates and dividends in relation to option pricing models, including the main significance they have on the possibility of early exercise of American Style options.

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:

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Factors for original option pricing models
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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 4:00PM 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 one-to-two days prior to the ex-dividend date.

Here is a summary of the minor factors found in the more recent option pricing models:

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Factors for original option pricing models
Click to Enlarge

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.

By Alan Ellman of TheBlueCollarInvestor.com

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