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Options Pricing

Published on Wednesday, April 4, 2018 | Modified on Monday, May 28, 2018

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Before getting started with trading options, you should have a good understanding of options pricing and the various factors that play a role in establishing the value of an option. There are also several option pricing models that are used to identify the value of a call or a put option. A solid understanding of options pricing factors and models will help you take advantage of price movements and optimize your earnings from your investments.

Understanding option pricing

Option pricing is the amount per share you have to pay to trade an option. The price of an option is also known as the premium. The buyer of an option needs to pay the premium amount to the seller to earn the rights granted by the option. Option premiums are priced per share. Since options are available in lots of shares called lot size, you need to pay:

Total Premium Amount= (premium price per share) X (lot size)

For example, say TCS option with a strike price of ₹2,500 is available at a premium of ₹20 per share for a lot size of 100 shares. To buy the option, you need to pay a premium amount of ₹20 X 100 = ₹2,000. The premium paid is non-refundable whether you choose to exercise your option or not.

What are the main factors determining an Option's Price?

There are many factors that influence the price of an option:

1. Value of the option's underlying asset

As we know, options are derived from underlying instruments like shares, gold, currency etc. The current value or price of the option's underlying instrument has a direct effect on the price of the call or put option. If the value of the underlying instrument is on the rise then the call option price will increase and put option price will decrease. If the price of underlying instrument decreases then call option price will decrease and put option price will increase.

2. Intrinsic Value of an Option

Intrinsic value refers to the value of the option if it were exercised today. It is calculated as a difference between the price of the underlying instrument from which the option is derived and strike price. The strike price is the price at which a buyer and a seller decided to enter the contract.

For call options, intrinsic value is calculated as-

Intrinsic Value = Spot Price - Strike Price

For put options, intrinsic value is calculated as-

Intrinsic Value = Strike Price - Spot Price

The intrinsic value of an instrument can only be positive and zero. It cannot be negative.

The intrinsic value of an option helps you in determining the profit advantage in case you wish to exercise the option immediately. It can be also called as the minimum value of an option.

3. Time Value of an Option

It is calculated as the difference between premium and intrinsic value.

Time Value = Premium-Intrinsic Value

The time value is directly related to how much time an option has until it expires. Generally, the longer the time for an option to expire, the higher is the premium. And it decreases as you come closer to the expiry date of the option.

4. Volatility

The volatility of the underlying instrument also plays a role in determining option pricing. Volatility is the probability of the price fluctuation (up or down) of the underlying instrument in the market. The higher the volatility of the underlying instrument, the higher the premium. It is because highly volatile stocks have a higher possibility of bringing profits to investors in a short time.

Volatility is of two types- historical and implied. Historical volatility measures the fluctuations observed in an underlying instrument in the past. Implied volatility predicts the fluctuations in the future.

5. Interest Rates

Normally interest rates have a nominal influence on options pricing. But it can be a factor if you are trading in options of large size. There is no direct effect of interest rates on options pricing. Its effect is related to the cost of funds. Let's assume that to trade in a large options contract, you decide to borrow money from banks or use funds from your savings that are earning some interest rates. Whichever way you go, you are paying interest on the loan or losing interest in case of savings. So the cost of your funds now is invested amount plus the interest on it. If the interest rate is high then the cost of money invested is also high. So when interest rates are high, the premium falls and vice versa.

6. Dividends on underlying stocks

In the event of dividend announcements during the life of an option, the exchanges adjust the option positions. As per regulations by SEBI, if the value of the dividend is more than 10% of the spot price of the option on the date the dividend in announced, then the strike price of the options are reduced by the dividend amount on ex-dividend dates. For dividends announced lower than 10% of the spot price, there is no adjustment by the exchange. Dividend announcement decreases the value of the option as the stock value decreases on ex-dividend date.

Effect of market factors on call option price and put option price

Factor Effect on Call Option Price Effect on Put Option Price
Increase in the value of the underlying instrument Increase Decrease
Increase in intrinsic value Decrease Increase
Increase in Time Value Increase Increase
Increase in Volatility Increase Increase
Increase in Interest rates Increase Decrease
Increase in Dividends Decrease Increase
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