Tuesday, February 26, 2013

Excellent Trading School - 26 - Frequently Asked Questions about Options Contracts - Part 2


Question: What are the factors that affect the price of an option?
Answer: There are five fundamental factors that affect the price of an option.These are:
1. Price of the underlying stock or index
2. Strike price/exercise price of the option
3. Time to expiration of the option
4. Risk-free rate of interest
5. Volatility of the price of underlying stock or index
Adjust the price for dividend expected during the term of the option to arrive at prices.

Question: What is volatility?
Answer: Volatility is the measure of speed of the movement of underlying prices.In other words it is the probability of the movement of underlying prices. For example, when it is said that daily volatility of the closing price of a stock is 2%, it means that there is 50% probability that the stock price can go up or down 2% from its previous close.

Question: Can you explain how the probability of price movement of the underlying helps to find the price of an option?
Answer: Consider this: suppose a stock is trading at Rs70. There is 40% probability that the stock price would move to Rs80. Similarly the probabilities of the price being Rs90, Rs100, Rs110 and Rs120 are 25%, 15%, 10% and 5% respectively. What would be your expected return if you were the buyer of a call option with a strike price of Rs100? If the stock price were to finish at Rs80, Rs90 and Rs100, the call option would expire worthless. If the stock price were to finish at Rs110 or Rs120, you would gain Rs10 and Rs20 respectively. Your expected return from the call would be: (40%*0)+(25%*0)+(15%*0)+(10%*10)+(5%*20) = 11.
This means that you would like to pay anything less than Rs11 for this option to make a profit and the seller would always like to get anything more than Rs11 for giving you this option.

Question: What happens in the real world?
Answer: It is possible to take “n” number of prices and assign different probability
numbers to each of the price to compute the expected return and the value of an
option. But in real world there are infinite number of possibilities and this approach
of computing price is not feasible. Alternatively, the volatility figure, which is nothing
but indicated probability, is taken to find the price of an option.

Question: Is there an easier way to find the theoretical price of an option?
Answer: Yes, there are scientific formulae available to compute the theoretical value of an option. The most popular mathematical model for computing the price of European style options is known as Black & Scholes model. Binomial model is used to find the fair value of premium of American style options. These formulae are complex mathematical functions and need fair amount of understanding of differential calculus, a branch of mathematics. Instead of spending too much effort in understanding the formulae, it is prudent to use ready-made tools for computing option prices. There are Excel sheets and software available for computing option prices which apply these algorithms. Put in the value of the five factors of an option into the software to find the theoretical price of the option.

Question: Can you explain option pricing with an example?
Answer: What would be the value of a June 27, 2012 Reliance Industries call option with Rs.300 strike price when Reliance Industries is trading at Rs.320, there are 30 days remaining in expiry, the risk-free interest rate is 8% and annual volatility of Reliance Industries’ price is 48%. Put in the value of the five factors in the option calculator, Suppose this price is Rs.35...

Question: I understand the price can be Rs.20 as I am getting the right to buy Reliance Industries shares at Rs.300 when Reliance Industries is quoting at Rs.320. Can you explain why I should pay Rs.35 for this option?
Answer: The difference of Rs.20 between the strike price and the spot price is the value this option is holding right now. If you pay Rs.20 and immediately exercise the option, you would neither gain nor lose. But this option is giving you the right to buy Reliance Industries shares at Rs.300 till June 27, 2012, which is 30 days away. The seller would like to get something for the risk of price rise during this period. Hence Rs15 (premium minus intrinsic value) is the time value of the option.

Question: Can you explain the pricing of a put option with an example?
Answer: What would be the value of an August 29, 2012 RIL  put option with Rs800 strike price when RIL is trading at Rs750, there are 30 days remaining in expiry, the risk-free interest rate is 8% and the annual volatility of RIL price is  40% Put in the value of the five factors in the option calculator, you find the price is Rs75...

Question: I can understand the price can be Rs.50 as I am getting the right to sell RIL shares at Rs.800 when RIL is quoting at Rs750. Can you explain why I should pay Rs75 for this option?
Answer: The difference of Rs50 between the spot and the strike price is the value this option is holding right now. If you pay Rs50 and exercise the option immediately, you would neither gain nor lose. But this option is giving you the right to sell ITC shares at Rs800 till August 29, 2002, which is 30 days away. The seller would like to get some money for the risk of price falling during this period. The time value of the option is Rs25 (premium minus intrinsic value).

Question: Can I say that premium is the sum of intrinsic and time value of option?
Answer: Yes. You can divide the premium of an option into two components:
intrinsic value and time value.

Question: Would the intrinsic value of a Reliance Industries call option with Rs.340 strike price be negative when Reliance Industries is quoting at  Rs320?
Answer: No. The intrinsic value of an option is never negative, though it can be zero. The entire premium of such options consists of time value only.

Question: Can time value be negative?
Answer: No. Like intrinsic value, time value too is never negative, though it can be zero.

Question: What is extrinsic value?
Answer: Extrinsic value is nothing but another term used to describe time value.
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