Option price involves two components – Intrinsic Value of Option and Option Premium.
Option premium is the value we get by subtracting the intrinsic value of option from the current market price of that particular option.
Only In-the-Money Options have intrinsic value (explained below). Time value of option and uncertainty in price of underlying security is reflected in option premium .
There are several factors affecting option prices. Some are more significant while others have less significance for trading purposes.
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If you take a look at an Option price calculator available in your trading account or Demat account, You would find the following factors affecting pricing of Options (Option Premium).
According to Black Scholes model of options pricing, the following factors affect the option prices :-
2. Underlying Security Price
3. Option Strike Price
4. Dividend per annum
5. Interest Rate per annum
6. Duration Left in Contact Expiry or Time Value.
The other factor which holds prime significance in Option Pricing and we mentioned above is the Intrinsic Value.
Considering Dividend and Interest Rate constant, rest of these are the major factors affecting the Option Premium.
Then there are more mathematical factors, known as Option Greeks, which have effect on the option premium.
These are Gamma, Vega, Delta, Rho.
Factors Affecting Option Prices
Option Volatility and Pricing
Volatility measures the possible price fluctuations in a security. Rise in Volatility leads to rise in Option Premiums.
Volatility is also correlated with Fear Factor. You would notice that before a big news announcement which may have a direct impact on that security, causes surge in Volatility.
Consequently, Option Premiums also rise compared to non-eventful trading days.
Underlying Security Price
Change in market price of an underlying security has direct effect on Option Price. That is the main theme for playing with Options for speculative traders.
When the market price of underlying security increases, the Call Options Premiums increase while the Put Options Premiums decrease.
On the other hand,when security price decreases, the Put Options Premiums increase while the Call Options Premiums decrease.
Option Strike Price
Different Strike Prices for an Option show different response to change in market price of underlying security.
Price change in Options prices is more for the Strikes which are near to current price of the underlying security.
The Strike Prices far away from the current price of the security see comparatively small change.
Duration Left In Contract Expiry or Time Value
This is also an important factor you can not ignore.
Each Option Contract has a fixed expiry date. With each passing day, the Option Premium keeps on decreasing, irrespective of the price changes in underlying security. This is called as Time Decay.
Some novice traders fail to recognize the importance of Time Decay. Consequently, they suffer from losses unknowingly.
Options Writers or Option Sellers use the Time Decay to their advantage. To take care of Time Decay, an Option trader who wants to buy an Option should prefer Option Strikes which are near the current price of the security.
Dividend and Interest Rate
They don’t hold much significance for trading purposes. They indicate the interest rate incurred on the cost of carrying the entire trade value and the Dividend yield on it.
This is the inherent value of an Option.
For a particular Option to have an Intrinsic Value, it is compulsory that the current market price of the underlying security has crossed that Option Strike.
These Options are called as In-The-Money Options.
The Option with Strike Price near to the security price is known as At-the-Money Option.
The far away Strike Price is known as Out-Of-Money Option.
Suppose a stock is trading currently at ₹ 1000. All Call Options with Strike Price below 1000 shall be In-The-Money.
A 980 Strike Call Option shall have an Intrinsic Value of 20 (Strike of 1020 would be At-the-Money while 1040 or higher are Out-of-Money).
For a Put Option, all the Put Options with Strike Price above 1000 shall be In-The-Money Options.
Here a Put Option with 1020 Strike Price shall have Intrinsic Value of 20 (Strike of 980 would be At-the-Money while 960 and lower are Out-of-Money).
Let us say, the price of 980 Strike Call Option for the above stock is ₹ 28 with stock price ₹1000. The price split for this Option would be 1000 – 980 = 20 (Intrinsic Value) + 8 (Premium) = 28.
Lower the Premium, the cheaper the Option is to buy.
At the time of expiry of Options Contract, what is left in an Option is only its Intrinsic Value (Last traded price of the security – Strike Price = Intrinsic Value).
The value of all Out-of-Money Option Strikes, above the last traded price for Call Options and below the last traded price for the Put Options, of the underlying security at the time of expiry turn to Zero (Remember, In-the-Money Options retain their Intrinsic Value even at expiry).
Understanding The Option Greeks
Delta – Delta measures how much the Option price is going to change with change in price of the underlying security.
It is the ratio of Change in Option Premium to Change in underlying security.
Suppose, with a change of ₹ 5 in underlying security, the Option price changes by 2, then Delta = 2 / 5 = 0.4
Thus a security with Delta of 0.4 would cause Option price to change by ₹2 if it changes by ₹ 5.
The value of Delta ranges between 1 to 0.
In-The-Money Option have Delta towards 1 while Out-of-the-Money Options have Delta towards zero.
Delta is useful to long term investors, for hedging their portfolios. Fearing a market fall in coming days, they would not want to sell their long term holdings in portfolios. In stead, they opt for hedging of portfolio by selling or writing Call Options.
How many Call Options to sell, they find via Delta.
Suppose an investor holds 1,00,000 shares of a particular company, for which the Delta Value is 0.5.
To hedge his portfolio against market downfall, he would need to sell 1,00,000 / 0.5 = 2,00,000 Call Options of that stock or Market Index (e.g Nifty) for whatever he chose Delta.
In case the markets fall, he will get the profit from these Calls equal to loss incurred to his portfolio of stocks.
Some investors pocket those profits while others prefer to buy more shares of that company with the profits.
Theta – Theta measure the change in Option Premium due to Time Decay.
Value of Theta gives value by which the Option Premium falls with each passing day.
Theta is a ratio of Change in Option Premium to Change in Time Duration left.
Gamma – Gamma tells about the rate at which the Delta is going to change with change in market price of underlying security.
Gamma is ratio of change in value of Gamma to change in market price of underlying.
Investors hedging the portfolios try to keep Gamma at small values.
Vega – Vega is for volatility.It measure the change in Option Price due to change in Volatility.
Vega is the ratio of change in Option Price to change in Volatility.
Rho – Rho measure the change in Option Price due to change in interest rates.
Here we find that Delta is the most useful of these Greek factors. Delta along with Gamma is applied in portfolio hedging.
For trading purposes, we can calculate the Option prices by using the Option Calculator itself. We need to know the Volatility to calculate the Option Price.
Volatility can be either calculated from the Option Calculator by having current Option price and security price or we can get Volatility by visiting the website of the concerned stock exchange.
Then we can use this volatility to calculate the expected Option Price after a particular number of days for any particular market price of the security.