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As we continue our journey on concepts on derivatives, let us take a closer look at options, type of options, what are option premiums and so on.
As discussed in our previous column, there are two types of options. Calls (option to BUY any security at a particular date at a particular price) and puts (option to SELL any security at a particular date at a particular price).
Options are classified as American (which can be exercised before the settlement date) and European (which can be exercised only on the settlement date).
An “exercise” is a process by which an option buyer can square off his existing position. This is generally done when the buyer is in the profit and the options are In-the-Money. In other words, writers of an American option bear an additional risk of the options getting exercised by the BUYer.
For example. Sterlite is trading at Rs 100 in the spot market on April 12, 2012. The expiry for the April series is on April 26, 2012.
A transaction takes place in the 105 strike call at Rs 2. As discussed earlier, stock options used to be American in Indian markets earlier. Suppose after 10 days the price of Sterlite moves to Rs 115.
The buyer of the option can exercise his right to buy the stock at 105 (the strike price). In that case, he books a profit of Rs 8 (115-105-2 (the premium paid by him)). The seller has to compulsory book the loss of Rs 8.
This creates a problematic situation wherein the writer could take any hedge position when the stock moves against his expected direction. All these premiums for various strike prices across three different expiries are traded on NSE.
Let's now discuss about how does the option premium gets priced. An option premium depends on various factors viz.
Price of the security takes note of strike price, time to expiry, implied volatility or the expected volatility of the options and interest rates.
Also, an option value is the sum of intrinsic value of the option and the time value.
Price of the Security: Price (premium) of a call option has a direct relation with the price of the security while the put option has inverse relation
Strike Price: Strike prices are classified as three types viz: In-the-Money (ITM), Out of-the- Money (OTM) and At-the-money (ATM). As the option gets In-the-Money, it tends to get costlier. A deep ITM option has a high intrinsic value but negligible time value. In case of an OTM option, it contains only time value.
Implied Volatility (IV): An option premium is directly proportional to the IV. The implied volatility is generally higher for the ATM options as these options have the highest sensitivity to the stock price while it tapers down for the OTM and ITM.
Time to expiry (T): Longer the expiry, higher would be the option premium.
Interest rates (I): Interest rates and option price are positively correlated on account of the leverage factor.
(The author is Vice-President – Research, Padmakshi Financial Services Ltd. The views are personal)
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