The Impact of Interest Rates on Options
Stock call options give the buyer the right to purchase a set number of shares at a stated price at any time over a specific time frame. Stock put options give the buyer the right to sell a set number of shares at a stated price over a specific time frame. When a buyer makes a purchase with the option it is called exercising the option. The purchase price under the option may be called an award price, strike price or exercise price. The goal with an option is to have the stock price rise higher than the strike price. This provides the buyer with a profit on the stock because it can be bought at a below-market value with the option and quickly resold.
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Setting the Option Price
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An option's strike price is usually the same as the stock's value at the time the option is granted, according to CNN Money. This is not always the case, though. The stock owner can set the price wherever he feels it is appropriate keeping in mind how long the option is good for. Most are valid for 10 years, CNN Money reports.
Factors in Determining Price
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While financial planners have different models they can rely on to help them calculate the price of an option, all models rely on the same factors: the actual share price of the stock, market volatility, length of time the option is valid, dividends and interest rates. The first three factors get the most attention, according to CNN Money, because they have the largest influence on the option price.
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Increasing Interest Rates
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When interest rates are on the rise, the cost of call options increases and the cost of put options decrease. This is because rising rates make call options more attractive as it is more likely the option can be sold at a profit, according to Forbes. Since there are only a set number of options that can be issued on the stock, more interest on the same amount of options creates a seller's market, in this case, a call options seller's market.
Decreasing Interest Rates
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When interest rates initially begin to fall, the cost of call options will decrease and the cost of put options will increase. This is because falling interest rates can indicate falling stock prices. If the stock value falls below the strike price of the put option, the option owner has the right to sell the stock at the higher price. However, Forbes notes when short-term interest rates fall below 2 percent, they will have little effect on option prices.
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