Technical Analysis

Determining option premium

Shaurya Mishra | Updated on July 14, 2012 Published on July 14, 2012


So how is the premium for the option calculated? Why is the premium for three months expiration time or high volatility stocks priced higher than the one month expiration time or low volatility stocks?

Premium of an option is determined by the factors discussed below.

Moneyness: It is a relationship between the strike price of an option and the current price of the underlying security. The difference between the strike and the spot price will determine the value or “moneyness” of the contract. In options trading “in the money”, “at the money” and “out of the money” describes the moneyness of the option.

A call option is in-the-money if the strike price is below the market price of the underlying security and a put option is in-the-money if the strike price is above the market price of the underlying security. So options which are in-the-money will have higher premium as chances of them expiring above the strike price is high.

A call or put option is at-the-money if the stock price and the exercise price are the same and thus premium for these options will be lower than in-the-money call option.

A call option is out-of-the-money if the strike price is above the market price of the underlying stock. A put option is out-of-the-money if the strike price is below the market price of the underlying stock. The premium for these kinds of option is lowest.

The above terms can be explained with the help of an example.

Let’s assume that there is a stock X trading at Rs 100. Now any call options with a strike price less than Rs 100 are in-the-money call options and put options with a strike price greater Rs 100 are in-the-money put options.

If strike price is at Rs 100 then it will be at-the-money for both call and put. Call options with strike price greater than Rs 100 and put options with strike price less than Rs 100 are out-of-the-money options.

Type of options: Vast majority of options traded in exchange are either American or European option. In American option, the buyer of the option can exercise his contract anytime up to the expiration date.

Whereas for European Option, the option can be exercised only at the end of the expiration date. Due to the flexibility in American option, the premium is higher than the European options.

Time to expiry : The higher the time left for expiration, higher is the chance of the underlying security moving in a favourable direction for the option buyer. Suppose you buy a call option for a stock which is trading at Rs 50. Let us assume the premium for one month contract is Rs 5. So the buyer of the option is only going to benefit if the price moves above Rs 55. Now suppose you are not sure whether the stock will move more than Rs 5 in one month but you are quite sure of the stock moving more than Rs 5 in two months. Since there is a favourable chance of the price of stock increasing more than Rs 5 in two months, this results in a higher premium for the option buyer.

We will be discussing about another three factors in the next column.

shaurya.mishra@thehindu.co.in

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