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…

Lot Sizes

Lot sizes Table:

Every option contract is worth the price of underlying multiplied by the quantity of underlying in the contract. In our example it was 10 Tonnes of Sugar Cane at 2000 Rs price so the contract was worth 20000 Rs. Now we would have simply split it in to 10 different contracts worth 2000 Rs for 1 Tonne of sugar cane in each contract. Or it could have been one contract worth 100 Tonne as well.

Exchange on its part tries to maintain each contract value roughly between Rs 2-3 Lacs. The table below gives you the lot size in contracts of various indices as well as few popular stocks. Entire list of lot sizes of all indices (7) stocks (228) can be found here.

The table above gives the lot sizes for near, next and far month contracts for indices as well as many blue chips. Please note that S&P500 and DJIA contracts are recently introduced so you will not see their near month lot size. Even the stock list also keeps changing from time to time.

Contracts for NIFTY are not limited to these three option chain till far month. NIFTY contracts as far as few years down the line are also tradable however most of the online brokers do not activate them for retail traders like you and I.

I trade primarily NIFTY unless something very interesting is happening in a sector index or a particular stock. For our trade, NIFTY lot size is 50 and Mini-NIFTY lot size is 20 which was started with the intention of increasing participation of retails and small investors in Derivatives market.

Now before I start posting actual trades and strategies behind them, we will have small explanation of Options pricing. As per my plan, I should be able to post my first trade post by this weekend. As I said earlier, follow that at your own peril.

Definitions... continued

My apologies for this delay in posting. Got caught up in an unplanned wedding of a friend (it was fun). Will try my best not to let it happen again (no not the wedding... I am talking about delay in posting).

Okay, so far we have seen Call, Put, Strike Price, Lot Size, Expiry Date and Open Interest and so on… only couple more are needed for you to gain tradable understanding of Options.

At the Money (ATM), In the Money (ITM), Out of the Money (OTM):

Positive/Negative or In Profit/In Loss being such complex terms... were neglected by ancient Option Traders. In all their wisdom they chose At the Money, In the Money and Out of the Money to denote loss/profit position of your Option contract. So as the name suggests, At the Money is you are neither making loss nor profit (that raises the question, why are you trading?), In the Money denotes that you are making money on your position and no prizes for guessing what Out of the Money means.

In the Money scenarios:

When you have bought Call (Long/Bullish) contract and now the market value is more than the Strike Price (+ expenses)

When you have bought Put (Short/Bearish) contract and the market value is less than Strike Price (+ expenses)

When you have sold Call (Long/Bullish) Option and market value is lesser than Strike Price (+ expenses)

When you have sold Put (Short/Bearish) contract and market value is more than Strike Price (+ expenses)

Out of the Money scenarios:

When you have bought Call (Long/Bullish) contract and now the market value is lesser than the Strike Price (+ expenses)

When you have bought Put (Short/Bearish) contract and the market value is more than Strike Price (+ expenses)

When you have sold Call (Long/Bullish) Option and market value is more than Strike Price (+ expenses)

When you have sold Put (Short/Bearish) contract and market value is less than Strike Price (+ expenses)

American / European Options:

No, it is not NRIs dealing in Indian Options.

In our example of sugar cane contract if the buyer has the liberty to exercise the contract any time before the validity of option then it is called as American Option. So essentially the buyer could ask the farmer to deliver sugar cane anytime after contract is done and till two months which is expiry date of that contract. (Please note that in this scenario, it may not be possible for farmer to deliver what is yet to be produced but actual settlement of Option Contracts is slightly different.)

However, if the contract says that I cannot exercise the Option before expiry date then it is a European type of Option. Please note that in India, all the Options are European type so you cannot exercise them before expiry date.

Option Settlement:

We would like to think that on expiry date, the farmer will deliver the sugar cane and buyer will pay the money. This is called as actual physical delivery settlement. However on Nifty, all the Options are cash settled. So if you have a call Option on Reliance at 1000 Strike Price and on expiry date, Reliance share price is 1050 then you get 50 Rs per Reliance Share in the contract. You don’t actually pay 1000 Rs per share and get the delivery of Shares. So the difference in market value and Strike Price is paid to you in cash.

The no of shares (or underlying) in one contract is called Lot Size. I will write on that in the next post. Then the last pre-trade post will be on Pricing of Options at a basic level. That’s the plan as of now. Let us hope that my other friends do not get inspired by the wedding last weekend and decide to rope me in again as a witness.