For the right to buy or sell a security at a specific price before a set date, the option buyer pays to the writer of the option a
premium. That is, the buyer pays a sum of money to the seller of the option. The amount of the premium is based upon several
factors. These are:
1) The market price of the security
2) Amount of time until expiration
3)
The volatility of the underlying security
4) Dividend rate
5) Tax-free interest rate
The higher the market
price of a security, the higher will be the premiums paid on that security when compared to lesser priced securities. The longer
the period of time until option expiration the higher the premium. This
is due to the longer period of time that the option has to get into-the-money. The higher the volatility of the underlying security,
the higher the premiums will be. This is due to the likelyhood of the more volatile security fluctuating into the money.
Interest
rates and dividend rates do not affect option premiums as significantly as the other factors. As interest rates increase the
market prices of stocks will tend downward...some more than others. This is good news for the call writer but bad for
the put writer. If a stock is likely to issue dividends often then that stock will be more desirable. That stock will
be more desirable to investors thus price will increase. This is bad for call writers but good for the put writers.
