Option Pricing

Pricing of Options:

Either we have to pay or we receive a price (premium) for purchasing or selling option. There are two components of this price/ Premium of an Option. These are;

Intrinsic Value

Time Value

Intrinsic Value:

If the market value is more than the strike price, then a call option is In the Money. The difference between the two is called as Intrinsic Value.

In simple words, it is the value by which is already available in the market. If you are holding NIFTY 5000 Call (Bullish/Long) option and NIFTY is at 5050 level then you already have 50 Rs advantage even if the option expires today. These 50 Rs is the intrinsic value of option.

Conversely if you are holding Put option and NIFTY is below strike price then your option has some intrinsic value which is the difference between strike price and NIFTY value.

So,

Intrinsic Value = Current Stock Price – Strike Price (Call Option)

                        = Strike Price – Current Stock Price (Put Option)

Time Value:

Option premium is always more than intrinsic value. This extra money is for the risk which option writer/seller is undertaking. This is called as Time Value.

Time value is the amount option trader is paying for a contract above its intrinsic value, with the belief that prior to expiration the contract value will increase because of a favourable change in the price of the underlying. Obviously, longer the amount of time till expiry of contract, the greater is the time value.

So,

Time Value = Option Premium – Intrinsic Value

There are many factors which determine Option Premium. These factors affect the premium of the option with varying intensity. I will list some of these factors in next post. Really tired today to write a long post…