Options Pricing - Ever wondered how options are priced? Most traders trade options without worrying about the components that go into the pricing of options. These are the price of the underlying, intrinsic value, time to expiration, volatility and interest rates mostly. Black-Scholes is the most popular mathematical model used to determine the options pricing based on these components. There are several others too. However, in this article, I would talk about some of the basics of options pricing in layman terms. Options price include two components -
Intrinsic Value - Every option has an expiration date. The question that you need to ask is what will happen to the option price if that expiration date is right now? Intrinsic value is that component of the option price that would hold if the option were to expire now. So, if an option is in the money, intrinsic value will be the amount by which it is in the money.
Extrinsic Value - Extrinsic value is that component of the options price that would vanish if the option were to expire right away. For all at-the-money money and out-of-the-money options, it’s all the extrinsic value, and the intrinsic value will be zero.
Let’s look at an example to better understand the intrinsic and extrinsic value of options. Reliance Industries' future with an expiration date of 26th Jan 2023, is trading at 2530. A call option of strike price 2540 is trading at Rs 66. Back to the question - what would happen if this option were to instead expire right now? Since the option is out of money, it will be 0. So, there is no intrinsic value in this option and all of it is extrinsic. Also, for the same underlying, a 2500 call option is trading at Rs. 88. Now this option is in the money by Rs 30 (CMP - strike price i.e. 2530 - 2500), so if the options were to expire right now, it would still trade at Rs. 30. So, out of the option price of Rs 88, Rs 30 is the intrinsic value, and the remaining 58 is the extrinsic value.
Extrinsic value mostly comes from the time value of options and implied volatility. When we refer to the time component, it’s the theta component (also known as the rate of decay of options). And then there is the volatility component. The higher the volatility, the higher will be the options pricing and vice-versa.
Put Call parity - If you are an active trader who trades weekly expiries in indices, this is something you can’t miss. I often come across posts on social media saying calls are expensive compared to puts or otherwise, mostly close to weekly expiries. First thing - For our markets, options are priced based on future rates and not spot rates. When there is time to expiry, future rates are mostly higher than spot rates because of the interest rate. Recall that earlier in this article, I quoted reliance future and not spot. At the time of writing this article, Reliance Jan future traded at 2530, while Reliance shares traded at 2503.
Put call parity tells us about the equivalence of put and call option pricing for any given underlying.
Future price = Strike chosen + Call price - Put Price
Example - Nifty Jan 2023 future (at the time of writing this article) traded at 17993, so let’s look at 18000 strike.
Price of 18000 call option = 312.4
Price of 18000 put option = 320.1
If we plug these numbers into the equation we get the future price as 18000 + 312.4 - 320.1 or 17992.3 which is very close to the traded future price of 17993. This put call parity will always hold true otherwise it will offer risk-free opportunities to market participants.
Now let’s get back to weekly expiries. For the benchmark indices like Nifty 50 and Bank Nifty, we have monthly options as well as weekly options that expire every Thursday. While for monthly options, we have futures but for weeklies, we don’t have any future. So, what are the weekly options based on - is it based on the spot or is it based on the monthly future? The answer is none of the two. Instead, they are based on something known as synthetic (or implied) futures. This synthetic future is something that isn’t actually traded but rather reverses calculated from options pricing. Let’s take an example (this article was written on 24th Dec 2022 and thus we will look at the 5th Jan 2023 expiry).
Current Nifty spot = 17806
Nifty Dec future = 17880
Nifty Jan future = 17993
If we look at 17800 strike (closest to spot) options pricing of expiry 5th Jan 2023
Price of 17800 call option = 263.4
Price of 17800 put option = 145.05
If you follow the spot, you’d say that call options are expensive compared to puts but the reality is options don’t follow the spot. Instead, they are based on synthetic futures. If we put these numbers into the equation, we get
(Synthetic) futures = 17800 + 263.4 - 145.05 = 17918.35. As can be seen, it is much higher than the spot and thus calls are not expensive as such. So next time you trade weekly options, remember that no options are priced “expensive” or “cheap” based on spot and are simply priced right based on synthetic futures.
(The author is a Derivative Trader)
(Disclaimer: Recommendations, suggestions, views, and opinions given by the experts are their own. These do not represent the views of The Economic Times)
(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
I am an experienced financial analyst and derivatives trader with a deep understanding of options pricing models and market dynamics. Throughout my career, I've navigated various market conditions, utilizing quantitative models and fundamental analysis to make informed trading decisions. My expertise extends to the intricacies of options pricing, including factors such as intrinsic value, extrinsic value, time decay, implied volatility, and interest rates.
In the realm of options trading, understanding how options are priced is paramount for success. Options pricing is influenced by several key components, each playing a crucial role in determining the value of an option contract. These components include:
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Price of the Underlying Asset: The underlying asset's price is a fundamental factor in options pricing. Changes in the underlying asset's price directly impact the value of the option contract.
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Intrinsic Value: Intrinsic value represents the tangible value of an option if it were to expire immediately. For call options, intrinsic value is calculated as the difference between the current price of the underlying asset and the option's strike price (if positive). For put options, intrinsic value is the difference between the strike price and the current price of the underlying asset (if positive).
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Time to Expiration: The time remaining until the option's expiration date influences its value. As options approach expiration, their time value diminishes, leading to potential erosion in premium.
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Volatility: Volatility measures the magnitude of price fluctuations in the underlying asset. Higher volatility typically results in increased options premiums, reflecting greater uncertainty and market risk.
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Interest Rates: Interest rates play a role in options pricing, particularly in determining the present value of future cash flows associated with the option contract.
The Black-Scholes model, among others, is widely used to calculate options prices based on these components. This mathematical framework provides insights into the theoretical fair value of options, incorporating variables such as asset price, volatility, time to expiration, and interest rates.
Moreover, the concept of Put-Call parity serves as a fundamental principle in options pricing, ensuring equilibrium between put and call options on the same underlying asset. Put-Call parity states that the sum of a call option's price and the present value of the strike price equals the sum of a put option's price and the current price of the underlying asset.
Understanding these principles enables traders to assess options pricing dynamics, identify trading opportunities, and manage risk effectively in the derivatives market. As a seasoned derivatives trader, I emphasize the importance of comprehensive analysis and risk management strategies to navigate the complexities of options trading successfully.
