If's and but's of Options Pricing - 1

Options Pricing – 1

Option pricing is a very popular topic for any students studying finance: it can get extremely technical and sometimes divorced from reality. Over the next two articles my aim is to provide you with the tools to understand how options are priced and what are the risks involved. Before we begin, let’s briefly recap what options are and how they work.

A call (put) option gives the holds the right but not the obligation to buy (sell) an asset at a particular price on a particular date. An example should help clarify this.

NIFTY is currently trading at 7500, and an investor buys a 3 month put option on Nifty with a strike price of 7500. This means that the investor has bought the right to sell NIFTY at RS 7500 in three months’ time. After three months if NIFTY has fallen below RS 7500 the investor will exercise the option and make a profit equal to the difference between RS 7500 and the market price. The investor's net profit will be deducted by the initial premium paid for the option.

Options generally take one of two forms: they are either European or American.

A European option allows exercise of the option only on the expiry date and an American option allows exercise at any time up to and including the expiry date.

 (Note that European and American arc just names. they have no relevance to what these options originate from. In general, it is never optimal to exercise an option prior to expiry no European and American options will usually behave in the sonic way. I will explain why this is the cast later in this tutorial.

The value of an option can be divided into two components, the intrinsic value and the time value.

The intrinsic value is equal to the difference between the strike price and the current market price. Effectively it is equal to what you would make if you were to exercise the option now. If NIFTY is trading at RS 7600 and we have a call option with a strike price of 7500 the intrinsic value of the option is 100. This is because if we exercised the option, we could buy NIFTY at RS 7500 and immediately sell at the current market price of RS 7600, making a profit of RS 100

An option will always be in one of three states and they are In the Money (ITM), At the money (ATM) and Out of the money (OTM).

An ITM option has positive intrinsic value: it is an option that if one were to exercise now one would make an immediate profit (like in the example in the previous paragraph which had a positive intrinsic value of RS 100).

An ATM option has a strike price equal to the current market price and this has no intrinsic value.

An example would be a NIFTY call option with a strike price of 7500. When the current market price is also 7500. In general, ATM options arc the most liquid.

An OTM option is one which also has no intrinsic value and the strike price is not equal to the market price.

An example would be a NIFTY call option with a strike price of 7600 and a market price at 7500

Now lets us move on to time value. The time value of the option is equal to the difference between the current option price and the intrinsic value.

 For example a NIFTY call option with a strike price of RS 7500 is trading at 20. The current market price is RS 7525.

The intrinsic value is RS 25 (7525-7500) and the time value is RS 5 (RS 25-RS 20).

The time value represents the premium that we pay for the option. As the option approaches expiry the time value component will decrease and when the option expires it will have no time value.

As you'd expect, longer dated options have a higher time value. Going back to what I said earlier about European and American options the reason that it is usually not optimal to exercise an option prior to expiry is that the investor would be giving up the time value. Because an option prior to expiry has positive time value the market price will always be higher than the intrinsic value. Therefore an investor is always better off selling the option at the market price rather than exercising it and receiving the intrinsic value.

The determinants of time value can be quite complex. Time value will depend on time to expiry, volatility, interest rates and how far OTM or ITM the option is, the options Greeks (delta, gamma, theta, vega & rho).