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How Interest Rates and Dividends Affect An Option's Price


Interest rates have a minimal effect on an option's value. When interest rates rise a call option's value will also rise, and a put option's value will fall.
To drive this concept home let's look at the decision-making process of trying to invest in TOP while it is trading at $50.
  • We can buy 100 shares of the stock outright which would cost us $5,000.
  • Instead of buying the stock outright we can get long an at-the-money call for $5.00. Our total cost here would be $500. Our initial outlay of cash would be smaller, and this would leave us $4,500 left over. Plus we will have the same reward potential for half the risk. Now we can take that extra cash and invest it elsewhere such as Treasury Bills. This would generate a guaranteed return on top of our investment in TOP.
The higher the interest rate, the more attractive the second option becomes. Thus, when interest rates go up, calls are a better investment, so their price also increases.
On the flip side of that coin if we look at a long put versus a long call, we can see a disadvantage. We have two options when we want to play an underlying to the downside.
  • You can short 100 shares of the stock which would generate cash into the brokerage and allow us to earn interest on that cash.
  • You long a put which will cost you less money overall but not put extra cash into your brokerage that generates interest income.
The higher the interest rate, the more attractive the first option becomes. Thus, when interest rates rise the value of put options drops.

Dividends

Options do not receive dividends, so their value fluctuates when dividends are released. When a company releases dividends, they have an ex-dividend date. If you own the stock on that date, you will be awarded the dividend. Also on this date, the value of the stock will decrease by the amount of dividend. As dividends increase a put option's value also increases and a calls' value decreases.
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