10.3 Options Pricing

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Understanding Pricing of Options
Before venturing into the world of trading options, traders should have a good understanding of
the factors that determine the value of an option. These include the current stock price, the
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FUTURES PRICI… intrinsic value, time to expiration or the time value, volatility, interest rates and cash dividends
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An option’s premium has two main components: intrinsic value and time value.
SETTLEMENT O…
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Intrinsic Value (Call)
A call option is in-the-money when the underlying security's price is higher than the strike price.
3 OPTIONS PRI… Intrinsic Value = Current Stock Price – Strike Price
4 SETTLEMENT O…
Intrinsic Value (Call) = Current Stock Price – Strike Price
Intrinsic Value (Put)
A put option is in-the-money if the underlying security's price is less than the strike price. Intrinsic
Value = Strike Price - Current Stock Price.
Intrinsic Value (Put) = Strike Price - Current Stock Price
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QUIZZES Time value is any premium in excess of intrinsic value before expiration. Time value is often
explained as the amount an trader is willing to pay for an option above its intrinsic value. This
amount reflects hope that the option’s price increases before expiration due to a favorable change
in the underlying security’s price. The longer the amount of time available for market conditions to
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b. Strike Price
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Changes in the underlying security price can increase or decrease the value of an option. These
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FUTURES PRICI… price changes have opposite effects on calls and puts. For instance, as the value of the underlying
security rises, a call will generally increase. However, the value of a put will generally decrease in 12
price. A decrease in the underlying security's value generally has the opposite effect.
SETTLEMENT O…
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2 The strike price determines whether an option has intrinsic value. An option's premium (intrinsic
value plus time value) generally increases as the option becomes further in-the-money. It
decreases as the option becomes more deeply out-of-the-money.
3
OPTIONS PRI… Time until expiration affects the time value component of an option's premium. Generally, as
expiration approaches, the levels of an option's time value decrease for both put and call. This
effect is most noticeable with at-the-money options.
4
SETTLEMENT O… The effect of implied volatility is subjective and difficult to quantify. It can significantly affect the
time value portion of an option's premium. Volatility is a measure of risk or variability of price of an
option's underlying security. Higher volatility estimates indicate greater expected fluctuations (in
either direction) in underlying price levels. This expectation generally results in higher option
premiums for put and call alike. It is most noticeable with at-the-money options.
The effect of an underlying security's dividends and the current risk-free interest rate has a small
but measurable effect on option premiums. This effect reflects the cost to carry shares in an
underlying security. Cost of carry is the potential interest paid for margin or received from
alternative investments and the dividends from owning shares outright.
KEY TAKEAWAYS:
Intrinsic value is the difference between Stock and Strike Price
Win a Badge! Time value is over and above the intrinsic value which a trader is willing to pay; the more the time to
expiry higher is the time value of option
QUIZZES Time value at expiry is zero; so the premium is equal to the Intrinsic Value

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1/28/2021 Options Pricing

BSE 500: 18200.73 -0.86% Pound to INR: 99.85 0.12%

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BSE 500: 18200.73 -0.86% Pound to INR: 99.85 0.12%

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Intrinsic Value (Put)

Intrinsic Value (Put) = Strike Price - Current Stock Price

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COURSE Factors having a significant effect on options

Derivatives a. Underlying stock price

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