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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