March 5, 2011 by akhilendra
Option Pricing
In addition to my previous post about Future and Options trading, today we are going to cover pricing in option. Option trading is very important as it is very economical and can offer great returns. But we need to understand it before we should enter it. One of the most important aspects of options trading is its pricing. Its pricing include;
Intrinsic value (Call Options)- When the strike price is below the current price, it is called In the Money call options.
Intrinsic value (Put Options)- When the strike price is above the current price, it is called In the Money Put options.
At the money- when the strike price is equals to the current market price, it is called At the money options.
Time Value- It is one of the most important factor in option trading. It depends upon the number of days remaining in expiry. Prior to expiration, any premium in excess of intrinsic value is called time value. Time value is also known as the amount an investor is willing to pay for an option above its intrinsic value. If the days remaining in expiry are more, chances of achieving the target is more, so the longer the amount of time for market conditions to work to an investor’s benefit, the greater the time value.
Price of underlying security- price can increase or decrease the value of an option. These price changes have opposite effects on calls and puts. Market price of a call option is directly proportional to the market price of security and inversely proportional for Put options. For example, if the value of the underlying security moves up, market price of a call option will increase and the value of a put will decrease in price and decrease in the underlying security’s value will increase the price of the put option.
The strike price determines whether or not an option has any intrinsic value. An option’s value (intrinsic value plus time value) generally increases as the option becomes more in the money, and decreases as the option becomes more out of the money.
Time Component-Time until expiration is a very significant component of option pricing, as discussed earlier, it affects the time value component of an option’s premium. Generally, as expiration approaches, the levels of an option’s time value, for both puts and calls, decreases or “erodes.” This effect is most noticeable with at-the-money options.
Volatility-The effect of volatility is the most subjective and perhaps the most difficult factor to quantify, but it can have a significant impact on the time value portion of an option’s premium. Volatility is simply a measure of risk (uncertainty), or variability of price of an option’s underlying security. Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike, and is most noticeable with at-the-money options. So if the security prices are moving in momentum in either directions, then volatility would be less and if prices are moving sideways, then volatility would be higher.
Interest rates- The effect of an underlying security’s dividends and the current risk-free interest rates also have it impact on option pricing. It have a small but measurable effect on option premiums. This effect reflects the “cost of carry” of shares in an underlying security — the interest that might be paid for margin or received from alternative investments (such as a Treasury bill), and the dividends that would be received by owning shares outright.
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