Option Pricing Fundamentals

 Prices are never fixed by stock exchanges or SEBI or anybody for that matter. In fact, price discovery is a very critical and basic component of markets. Stock exchanges only provide a platform where buyers and sellers meet, and SEBI’s role is to ensure smooth functioning of our markets. Any option’s value increases or decreases depending upon different variables. Each variable has its impact on an option. The impact can be the same or different for a call and a put option.

As explained in the earlier section, option premium is the sum of intrinsic value and time value. As long as the option has not expired, there will always be some time value. Intrinsic value may or may not be there, depending upon whether the option is ITM, ATM or OTM.

Time value of the option in turn depends upon how much time is remaining for the option to expire and how volatile is the underlying. Thus, there are five fundamental parameters on which the option price depends upon:

1) Spot price of the underlying asset

2) Strike price of the option

3) Volatility of the underlying asset’s price

4) Time to expiration

5) Interest rates

These factors affect the premium/ price of options (both American & European) in several ways.

• Spot price of the underlying asset

The option premium is affected by the price movements in the underlying instrument. If price of the underlying asset goes up, the value of the call option increases, while the value of the put option decreases. Thus, when Nifty rises from 17500 to 18000, the price of a call option with a strike price of 17500 will increase, while the price of a put option with the same strike price will fall. Similarly, if the price of the underlying asset falls, the value of the call option decreases while the value of the put option increases.

• Strike Price

If all the other factors remain constant but the strike price of option increases, intrinsic value of the call option will decrease and hence its value will also decrease. For example, when Nifty is at 17562, a call option with a strike price of 17600 will trade at a higher price than a call option with the same maturity but with a strike price of 17700. This is because the intrinsic value is progressively lower for higher strike prices of calls. On the other hand, with all the other factors remaining constant, increase in strike price of option increases the intrinsic value of the put option which in turn increases its option value. Thus, a put option with a strike price of 17700 will trade at a higher premium than a put option with the same maturity but a strike price of 17600.

• Volatility

It is the magnitude of movement in the underlying asset’s price, either up or down. It affects both call and put options in the same way. Higher the volatility of the underlying stock, higher the premium because there is a greater possibility that the option will move in-the-money during the life of the contract. Hence, when the index or stock volatility shoots up because of some unexpected event, the prices of both calls and puts on the index or stock will increase. Higher volatility = Higher premium, Lower volatility = Lower premium (for both call and put options).

• Time to expiration

The effect of time to expiration on both call and put options is similar to that of volatility on option premiums. Generally, longer the maturity of the option, greater is the uncertainty and hence the higher is the premium. Thus, an option with a strike price of 17500 and maturing in October 2021 will generally trade at a higher price than an option with the same strike price but expiring in September 2021. If all other factors affecting an option’s price remain the same, the time value portion of an option’s premium will decrease with the passage of time. This is also known as time decay. Options are known as ‘wasting assets’, due to this property where the time value gradually falls to zero.

It is also interesting to note that of the two component of option pricing (time value and intrinsic value), one component (the Time Value) is inherently biased towards reducing in value. So, if all things remain constant throughout the contract period, the option price will always fall in price by expiry. Thus, option sellers are at a fundamental advantage as compared to option buyers as there is an inherent tendency in the price to go down.

• Interest Rates

Interest rates are slightly complicated because they affect different options, differently. For example, interest rates have a greater impact on options with individual stocks an d indices compared to options on futures. To put it in a simpler way, high interest rates  will result in an increase in the value of a call option and a decrease in the value of a put option.