Option Pricing

There are many factors which determine Option Premium. These factors affect the premium of the option with varying intensity. Some of these factors are listed here;

Price of the Underlying: Any fluctuation in the price of the underlying (stock/index/commodity) obviously has the largest impact on premium of an option contract. An increase in the underlying price increases the premium of call option and decreases the premium of put option. Reverse is true when underlying price decreases.

Strike Price: How far is the strike price from spot also has an impact on option premium. Say, if NIFTY goes from 5000 to 5100 the premium of 5000/5100 strike will change a lot compared to a contract with strike of 5500 or 4700.

Time till Expiry: Lesser the time to expiry, option premium follows the intrinsic value more closely. On the expiry date Time Value approaches zero.

Volatility of Underlying: Underlying security is a constantly changing entity. The degree by which its price fluctuates can be termed as volatility. So a share which fluctuates 5% on either side on daily basis is said to have more volatility than let’s say a stable blue chip shares whose fluctuation is more benign at 2-3%. Volatility affects calls and puts alike. Higher volatility increases the option premium because of greater risk it brings to the seller.

Apart from above, other factors like bond yield (or interest rate) also affect the premium. This is due to the fact that the money invested by the seller can earn this risk free income if invested in bonds and hence while selling option; he has to earn more than this because of higher risk he is taking.

Sometimes dividend payment by an underlying is also factored in to the premium as it affects the cost of buying those shares directly rather than buying the option.

There are other factors too which I will touch upon as and when opportunity presents itself during our trading posts and strategies.

Fortunately for us we do not have to take all these factors and do some complex spreadsheet calculation for finding out premium. There are many models developed for options pricing one of which (and most popular) is Black & Scholes pricing model. The two professors, Fischer Black & Myron Scholes, won a Nobel Prize in Economics for its creation. Though its knowledge is not a precursor to options trading, a little bit extra knowledge has not killed anybody.  At least not anyone I know of. Read about it here and let me know if you felt any uneasiness after reading it.

I will post a table which shows variation in the premium of option over a period of time in next post.

Stay tuned and fasten your seat belt as the ride is gonna get bumpy here after...