How Options Are Priced

Option Pricing - Overview

When we deal with futures the value of a contract is what someone must pay to buy or what someone would receive to sell out of it. A futures contract has zero value at the start of the contract, but the value turns positive or negative as prices or rates change. A contract that has a positive value to one party and negative value to the counter-party can turn around and have negative value to the former and positive value to the later as the price changes.

With options, these concepts are different. An option has a positive value at the start. The buyer must pay money and seller receives money to initiate the contract. Prior to expiration, the option always has a positive value to the buyer and a negative value to the seller.

Before I start, we will make a simple assumption that participants in the market behave in rational manner and take advantage of arbitrage opportunities. However, it has been observed that option traders many a times do not understand the logic behind the pricing of stock and index options.

As we all know volatility means the fluctuation in the price of a stock, as it is quickly moving up and down. Same way for options we have Implied Volatility, which help trader to determine the correct option price. This blog will cover how options are priced.

What is Implied Volatility?

Implied volatility is a dynamic that changes based on activity in the options marketplace. Usually, when implied volatility increases, the price of options will increase as well (and vice versa)

Implied volatility represents the expected volatility of a stock over the life of the option.  Implied volatility is directly influenced by the supply and demand of the underlying options and by the market's expectation of the share price's direction. As expectations rise, or as the demand for an option increases, implied volatility will rise. Options that have high levels of implied volatility will result in high-priced option premiums. Conversely, as the market's expectations decrease, or demand for an option diminishes, implied volatility will decrease. Options containing lower levels of implied volatility will result in cheaper option prices. This is important because the rise and fall of implied volatility will determine how expensive or cheap time value is to the option.

How Options are Priced

Option pricing is always based on two important factors: intrinsic value and the time value of the option.

The intrinsic value of a call is the amount the option is ITM, if it is ITM. If the call is OTM, its intrinsic value is zero and opposite in case of put. For example: - If a stock is trading at Rs. 100 and you owned a call option with the strike price of Rs. 80. The intrinsic value of this option is Rs. 20 (100 - 80).

The time value of an option is the difference between its premium and its intrinsic value. Both calls and puts have time values. An option that is OTM or ATM has only time value. Usually, the maximum time value exists when the option is ATM. The longer the time to expiration, the greater is an option's time value, all else equal. At expiration, an option should have no time value.

For Example: - If we take the same example which we used for intrinsic value and let’s say the option premium is now Rs. 25 where the intrinsic value is Rs. 20, which means time value is the additional premium (Rs.5)which is present in the option.

How is Implied Volatility Calculated

We can calculate the implied volatility with the help of option calculator which is present in our trading platform, which is based on the famous Black- Scholes formula.

Conclusion

The majority of new traders in options and the traders who are doing trading for some time frequently wonder who is buying an option when everyone is selling and vice versa. They might see markets dropping or a particular stock dropping, in which case  they might join the ride and begin buying puts (and in case of upward move might go on with buying calls). Without knowing the exact option price, it is very dangerous to buy or sell options.

High volatility has an extremely strong effect on option prices. Higher volatility increases the call and put prices because it increases possible upside values and increases possible downside value of the underlying. The upside effect helps calls and does not hurt puts. The downside effect does not hurt calls and help puts. The reason calls are not hurt and on the downside and puts are not hurt on the upside is that when options are out of the money, it does not matter if they end up more out of the money. But when options are in the money, it does matter if they end up more in the money.

Volatility is a critical variable in pricing option. It is the only variable that affects option prices that is not directly observable either in the option contract or in the market. It must be estimated.