In our last article we have described the basics of ?Option and Its Terminologies?. You can get through the Article by Clicking Here
Option Trading Simplifies-
In very simple terms option trading involves buying and selling options contracts on the exchanges and, broadly you can think it very similar to stock trading, but in practice it is a little bit complicated than stock trading. Similar to trading in stocks to make profits through buying stocks and selling them at a higher price, one can buy options contracts and selling them at a higher price. One can also sell the option and benefit through getting the premium if the option buyer do not excise his option contracts. Unlike trading in stocks that give you a small piece of ownership in the company, options are just contracts that give you the right to buy or sell the stock at a specific price (strike price of the option) on a specific date (expiry date of the option contract).
There are two types of options – call and put.
CALL OPTION-
The ?Call Option? gives the holder (buyer) of the option the right to buy a particular asset at the strike price on or before the expiration date in return for a premium paid upfront to the seller. Call options usually become more valuable as the value of the underlying asset increases.
PUT OPTION-
The Put Option gives the holder (buyer) the right to sell a particular asset at the strike price anytime on or before the expiration date in return for a premium paid up front. Since you can sell a stock at any given point of time, if the spot price of a stock falls during the contract period, the holder is protected from this fall in price by the strike price that is pre-set. This explains why put options become more valuable when the price of the underlying stock falls. Similarly, if the price of the stock rises during the contract period, the option holders only loses the premium amount and does not suffer a loss of the entire price of the asset. Put options are abbreviated as ?P? in online quotes.
How an Option Price is determined-
Understanding how an Option Price is determined isn?t nearly as difficult as you might think. And it can be simple if you break it down into easy to understand components.
An option?s price is a combination of intrinsic and extrinsic i.e. time values.
Option Price = Intrinsic Value + Time Value
Intrinsic value is the amount an option is in the money (ITM). An option is ITM if it can be exercised to buy the stock below the current price or sell the stock above the current price. Being able to do that is ?intrinsically? valuable. In other words if you have bought a call option at the strike price say Rs.100 of a stock and now the spot or current price is above the strike price say Rs.110, than you are in the money. Just opposite to this if you have bought a put option of a stock at a strike price of Rs.100 and now the current price of the stock is Rs.85, you are in the money. So, ITM options have intrinsic value. If an option is out of the money (OTM), it has zero intrinsic value.
The extrinsic value of an option is however much of its price that isn?t intrinsic value. It?s also known as an option?s time value. Extrinsic value is the premium option buyers pay and option sellers charge to compensate for the future uncertainty of how much the price of a stock will change between now and the option?s expiration. Time value is higher when the market thinks the price of the stock will be more volatile and/or there is more time to expiration. The reason option buyers are willing to pay more for time value if they think the stock will make a large enough move up or down and make their option more valuable. Similarly, option sellers demand additional extrinsic value to take on the risk of the stock price moving against them.
How are intrinsic and time values calculated?
A call option?s intrinsic value is the current stock price minus the call?s strike price.
Ex: Rs.100.00 call in an underlying at Rs.110.00
Rs.110.00 ? Rs.100.00 = Rs.10.00 intrinsic value
A put option?s intrinsic value is the put?s strike price minus the current stock price.
Ex: Rs.100.00 put in an underlying at Rs.85.00
Rs.100.00 ? Rs.85.00 = Rs.15.00 intrinsic value
Calculating an option?s extrinsic value is what formulas like Black Scholes are for. They incorporate the expected volatility of the stock price, days to expiration (DTE), interest rates and dividends to determine how much ?time value? an option has. But rather than worry about how the extrinsic value is calculated, it?s more important to understand how to interpret it.
Extrinsic value is the result of competing forces of supply and demand. Option sellers, the ?supply?, ask for extrinsic value to cover their risk and as profit if the stock doesn?t have a large price change, and option buyers, the ?demand?, bid for extrinsic value to profit if the stock has a large price change. The buyers bid and sellers ask, and basically negotiate an extrinsic value that matches both their expectations of how much the price of the stock might go up or down.
Option Greeks
From the above option pricing discussion you can understand that a lot of factors that causes the time value of an option price or premium. These factors are collectively known as ?The Option Greeks?. These forces influence an option contract in real time, affecting the premium to either increase or decrease on a minute by minute basis. To make matters complicated, these forces not only influence the premiums directly but also influence each another.
Options Premiums, options Greeks, and the natural demand supply situation of the markets work as independent agents, yet they influence each other and factored in the final option premium price.
Below are the types of ?Option Greeks? that you must be aware of:
- Delta: Delta is a measure of the rate of change in an option’s theoretical value for a one-unit change in the price of the underlying. Call deltas are positive; put deltas are negative, reflecting the fact that the put option price and the underlying price are inversely related.
- Gamma: Gamma is a measure of the rate of change in an option’s delta for a one-unit change in the price of the underlying. Long options will always have Positive Gamma and Short options will always have Negative Gamma.
- Vega: Vega is a measure of the rate of change in an option’s theoretical value for a one-unit change in the volatility assumption (Implied Volatility or IV). If the Vega is high then option will rapidly gain or lose value. It is also known as Kappa.
- Theta: Theta is a measure of the rate of change in an option’s theoretical value for a one-unit change in time to the option’s expiration date. This price decrease accelerates as the expiration date approaches. American options Theta will always be positive while European options Theta can be Negative or Positive.
- Rho: Rho is a measure of the expected change in an option’s theoretical value for a 1 percent change in interest rates. An increase in risk free interest rate increases the value of calls and decreases the value of puts and vice versa.
Volatility- A measure of stock price fluctuation. Mathematically, volatility is the annualized standard deviation of a stock’s daily price changes.
Premium- is the price of an option and is equal to its intrinsic value plus time value.
Theoretical value- The estimated value of an option derived from a mathematical model.
- Delta:?(? or ?)
The most important of the ?Greeks? is the option?s ?Delta?. Delta measures the sensitivity of the option value to a given small change in the price of the underlying asset. It may also be seen as the speed with which an option moves with respect to price of the underlying asset.
Delta = Change in option premium/ Unit change in price of the underlying asset.
Delta for call option buyer is positive, between 0 and 1. This means that the value of the contract increases as the share price rises. Delta for call option seller will be same in magnitude but with the opposite sign (negative).
Delta for put option buyer is negative, between 0 and -1. The value of the contract increases as the share price falls. That means if the stock goes up and no other pricing variables change, the price of the option will go down. Delta for put option seller will be same in magnitude but with the opposite sign (positive).
The knowledge of delta is of vital importance for option traders because this parameter is heavily used in margining and risk management strategies. The delta is often called the hedge ratio, e.g. if you have a portfolio of ?n? shares of a stock then ?n? divided by the delta gives you the number of calls you would need to be short (i.e. need to write) to create a hedge. In such a ?delta neutral? portfolio, any gain in the value of the shares held due to a rise in the share price would be exactly offset by a loss on the value of the calls written, and vice versa.
- Gamma:?(?)
Gamma measures change in delta with respect to change in price of the underlying asset. Gamma works as an acceleration of the delta, i.e. it signifies the speed with which an option will go either in-the-money or out-of-the-money due to a change in price of the underlying asset.
Gamma = Change in an option delta/ Unit change in price of underlying asset
Since a Delta is only good for a given moment in time, Gamma tells you how much the option’s Delta should change as the price of the underlying stock or index increases or decreases.
How Delta is expected to change given a $1 move in the underlying is called Gamma. An investor can see how the Delta will affect an option’s price given a $1 move in the underlying, but to see how the Delta on that option might change given the same $1 move, we refer to Gamma. Gamma will be a number anywhere from 0 to 1. Since Delta cannot be over 1, Gamma cannot be greater than 1 either as Gamma represents the anticipated change in Delta.
- Vega:?(?)
Vega is a measure of the sensitivity of an option price to changes in market volatility. It is intended to tell you how much an option’s price should move when the volatility of the underlying security or index increases or decreases.
Vega = Change in an option premium/ Change in volatility
Volatility is one of the most important factors affecting the value of options. Implied volatility tends to increase when there is uncertainty or anticipated news, while it tends to decrease in times of calm. When volatility increases option prices for both calls and puts also increases. When volatility decreases option prices for both calls and puts also decreases. Vega does not have any effect on the intrinsic value of options; it only affects the ?time value? of an option?s price.
Longer-term options tend to have higher Vega than near-term options. Typically, as implied volatility increases, the value of options will increase. That?s because an increase in implied volatility suggests an increased range of potential movement for the stock. A drop in Vega will typically cause both calls and puts to lose value. An increase in Vega will typically cause both calls and puts to gain value.
- Theta:?(?)
Theta measures of an option?s sensitivity to time decay. Theta is the change in option price for a one-day decrease in time to expiration. Simply put, Theta tells you how much the price of an option should decrease as the option nears expiration.
Theta = Change in an option premium/ Change in time to expiry
Since options lose value as expiration approaches, Theta estimates how much value the option will lose, each day, if all other factors remain the same.
Because time-value erosion is not linear, Theta of at-the-money (ATM), just slightly out-of-the-money and in-the-money (ITM) options generally increases as expiration approaches, while Theta of far out-of-the-money (OOTM) options generally decreases as expiration approaches. Upon expiration, an option has no time value and trades only for intrinsic value, if any.
Usually theta is negative for a long option, whether it is a call or a put. Other things being equal, options tend to lose time value each day throughout their life. This is due to the fact that the uncertainty element in the price decreases.
- Rho:?(?)
Rho is the measure of an option’s sensitivity to interest rate changes. It is the change in option price given a one percentage point change in the risk-free interest rate. It tells you how much the price of an option should rise or fall if the ?risk-free? (U.S. Treasury-bill)* interest rate increases or decreases. Rho measures the change in an option?s price per unit increase in the cost of funding the underlying.
Rho = Change in an option premium/ Change in cost of funding the underlying
As interest rates increase, the value of call options will generally increase. As interest rates increase, the value of put options will usually decrease. For these reasons, call options have positive Rho and put options have negative Rho.
If you are trading shorter-term options, changing interest rates shouldn?t affect the value of your options too much. But if you are trading longer-term options such as LEAPS, rho can have a much more significant effect due to greater ?cost to carry.?
Similar to Vega, interest rate changes impact longer-term options much more than near-term ones. Rho is positive for purchased calls as higher interest rates increase call premiums. Conversely, Rho is negative for purchased puts as higher interest rates decrease put premiums.
The higher the price of the stock and the longer time until expiration generally means a greater sensitivity to changes in interest rates (higher absolute Rho values).
This article is to give you a brief introduction about ?Option Pricing And Option Greeks?. In our next article ?PART-III? we will discuss more detail with real-time example and also learn some more like ?Option Strategies?. To read more stay tuned with us?