Option valuation: Introduction

From this post onwards we will be discussing the various aspects of option pricing. The price of an option at expiry has been already discussed. Now, we need to find out the value of options before expiry- for that,

First, we lay down the factors that affect option price:

  • Strike price – You will have to pay a higher premium, if the strike price of a call is low. For example – if the value of HDFC call with a strike price of 500 is Rs 10, then the value HDFC call with a strike price of 480 would be higher than Rs 10, say 12. Simple logic, since, a lower strike gives the holder the right to buy that share at a lower price. Hence, it’s more valuable and premium will be high.

Puts with higher strike prices will also command higher premium. The reason is that it gives the buyer a right to sell the stock at a higher price.

Hence, the basic rule would be:

For  calls: Lower the strike, higher the premium

For  Puts: Higher the strike, higher the premium.

  • Spot price of the underlying asset- If you recall the article on Moneyness of options, we learned that an option can be in the money, at the money or at of the money depending on how the underlying asset price has moved. Therefore, if the underlying asset price is at high levels, a call option that’s in the money should also have a high value. Similarly, if the underling asset price is at very low levels, a put option that’s in the money should have a higher value.

So spot price of the underlying asset is a major factor that affects the price of an Option.

We summarize the position here:

For calls: Higher the spot price, higher the premium

For Puts: Higher the spot price, lower the premium.

  • Time to expire – when you give more time for an asset to float in the market, the chances of its price moving higher is more. Hence, when more time remains for an option to expire, the chances for that option to move in the money is more. That means, more the time remaining to expire, higher the premium.

Thus, a three month option will have a higher premium than a one month option with the same strike price. The impact will be-

For calls: More time to expiry, greater the premium

For puts: More time to expiry, greater the premium. (Same logic will apply)

  • Volatility of the underlying asset – we understood from the above two points that spot price influences the option’s price and more the time remaining to expiry, the higher the value of an option. Now, along with this, if the stock is highly volatile in nature, it further increases the chances to hit highs. Naturally, option holders are in a better position since their risk is one sided. Volatility increases a call holder’s chances to hit Maximum.In any case,  they lose only the  premium paid. On the other hand, option writers, in such cases, face higher risk and they have to be compensated more to bear more risk.

Hence, higher the volatility of the underlying, higher the premium.

For calls: Higher the asset volatility rate, higher the premium

For puts: Higher the asset volatility, higher the premium.

  • Risk free rate – as the risk free interest rate increases, the present value of future strike price decreases and hence, the option price increases. That’s because, in the case of calls you are deferring an expenditure (buying those shares) and in the case of puts, you are deferring the receipt of income. That’s straight logic. connecting that to calls and puts, the position will be as follows-

For calls: higher the interest rate, higher the premium

For puts: Higher the interest rate, lower the premium.

  • Dividends- dividends when declared, reduces the share price to that extent. Hence it reduces the value of call and increases the value of a put.

Hence,

For calls: Higher the dividend declared, lower the call value.

For Puts: Higher the dividend declared, higher the put value.

There are different models used by option traders to value an option before expiry. Option vales will be influenced by the changes in each of the above factors. In the next article we will look at some more topics which is required to get a grip on valuation of options.

You may like these posts:

  1. Options: Moneyness.
  2. Options: Put-Call parity-Part I
  3. Options: Option styles

1 Response to “Option valuation: Introduction”

hasmit

August 29, 2013 at 12:43 pm

This is soo nicely explained ,thanks a lott sir for this wonderfull job………..

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