While the math behind options-pricing models may seem daunting, the underlying concepts are not. The variables used to come up with a "fair value" for a stock option are the price of the underlying stock, volatility , time, dividends and interest rates. The first three deservedly get most of the attention because they have the largest effect on option prices. But it is also important to understand how dividends and interest rates affect the price of a stock option.

These two variables are crucial to understanding when to exercise options early. Black Scholes Doesn't Account for Early Exercise The first option pricing model, the Black Scholes model , was designed to evaluate European-style options , which don't permit early exercise. So Black and Scholes never addressed the problem of when to exercise an option early and how much the right of early exercise is worth.

Being able to exercise an option at any time should theoretically make an American-style option more valuable than a similar European-style option, although in practice there is little difference in how they are traded. Different models were developed to accurately price American-style options.

Most of these are refined versions of the Black Scholes model, adjusted to take into account dividends and the possibility of early exercise. To appreciate the difference these adjustments can make, you first need to understand when an option should be exercised early. And how will you know this? In a nutshell, an option should be exercised early when the option's theoretical value is at parity and its delta is exactly That may sound complicated, but as we discuss the effects interest rates and dividends have on option prices, I will also bring in a specific example to show when this occurs.

First, let's look at the effects interest rates have on option prices, and how they can determine if you should exercise a put option early. The Effects of Interest Rates An increase in interest rates will drive up call premiums and cause put premiums to decrease. To understand why, you need to think about the effect of interest rates when comparing an option position to simply owning the stock.

Since it is much cheaper to buy a call option than shares of the stock, the call buyer is willing to pay more for the option when rates are relatively high, since he or she can invest the difference in the capital required between the two positions. When interest rates are steadily falling to a point where the Fed Funds' target is down to around 1. All the best option analysis models include interest rates in their calculations using a risk-free interest rate such as U.

Interest rates are the critical factor in determining whether to exercise a put option early. A stock put option becomes an early exercise candidate anytime the interest that could be earned on the proceeds from the sale of the stock at the strike price is large enough.

Determining exactly when this happens is difficult, since each individual has different opportunity costs , but it does mean that early exercise for a stock put option can be optimal at any time provided the interest earned becomes sufficiently great. The Effects of Dividends It's easier to pinpoint how dividends affect early exercise. Cash dividends affect option prices through their effect on the underlying stock price. Because the stock price is expected to drop by the amount of the dividend on the ex-dividend date , high cash dividends imply lower call premiums and higher put premiums.

While the stock price itself usually undergoes a single adjustment by the amount of the dividend, option prices anticipate dividends that will be paid in the weeks and months before they are announced. The dividends paid should be taken into account when calculating the theoretical price of an option and projecting your probable gain and loss when graphing a position.

This applies to stock indices as well. The dividends paid by all stocks in that index adjusted for each stock's weight in the index should be taken into account when calculating the fair value of an index option. Because dividends are critical to determining when it is optimal to exercise a stock call option early, both buyers and sellers of call options should consider the impact of dividends. Whoever owns the stock as of the ex-dividend date receives the cash dividend , so owners of call options may exercise in-the-money options early to capture the cash dividend.

That means early exercise makes sense for a call option only if the stock is expected to pay a dividend prior to expiration date.

Why a decrease in risk-free rate of interest will decrease call option values and increase put option values? | AnalystForum

Traditionally, the option would be exercised optimally only on the day before the stock's ex-dividend date. But changes in the tax laws regarding dividends mean that it may be two days before now if the person exercising the call plans on holding the stock for 60 days to take advantage of the lower tax for dividends.

To see why this is, let's look at an example ignoring the tax implications since it changes the timing only. Say you own a call option with a strike price of 90 that expires in two weeks. The call option is deep in-the-money, and should have a fair value of 10 and a delta of So the option has essentially the same characteristics as the stock. You have three possible courses of action:. Which of these choices is best? If you hold the option, it will maintain your delta position.

That is not because of any additional profit, but because you avoid a two-point loss. You must exercise the option early just to ensure you break even. What about the third choice - selling the option and buying stock? This seems very similar to early exercise, since in both cases you are replacing the option with the stock. Your decision will depend on the price of the option. In this example, we said the option is trading at parity 10 so there would be no difference between exercising the option early or selling the option and buying the stock.

But options rarely trade exactly at parity. So the only time it makes sense to exercise a call option early is if the option is trading at or below parity, and the stock goes ex-dividend tomorrow. Conclusion Although interest rates and dividends are not the primary factors affecting an option's price, the option trader should still be aware of their effects. In fact, the primary drawback I have seen in many of the option analysis tools available is that they use a simple Black Scholes model and ignore interest rates and dividends.

Remember, when you are competing in the options market against other investors and professional market makers , it makes sense to use the most accurate tools available. To read more on this subject, see Dividend Facts You May Not Know. Dictionary Term Of The Day. A measure of what it costs an investment company to operate a mutual fund. Latest Videos PeerStreet Offers New Way to Bet on Housing New to Buying Bitcoin? This Mistake Could Cost You Guides Stock Basics Economics Basics Options Basics Exam Prep Series 7 Exam CFA Level 1 Series 65 Exam.

Sophisticated content for financial advisors around investment strategies, industry trends, and advisor education. Dividends, Interest Rates And Their Effect On Stock Options By Jim Graham Share.

You have three possible courses of action: Do nothing hold the option. Exercise the option early. Sell the option and buy shares of stock. There are times when an investor shouldn't exercise an option.

Find out when to hold and when to fold.

Learn how the distribution of dividends on stocks impacts the price of call and put options, and understand how the ex-dividend date affects options. We look at strategies to help manage taxes and the exercise of incentive and non-qualified stock options.

The ability to exercise only on the expiration date is what sets these options apart. A brief overview of how to profit from using put options in your portfolio. Options are valued in a variety of different ways. Learn about how options are priced with this tutorial. Learn the top three risks and how they can affect you on either side of an options trade. These two options have many similar characteristics, but it's the differences that are important. Learn how the strike prices for call and put options work, and understand how different types of options can be exercised Once a put option contract has been exercised, that contract does not exist anymore.

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