Do the Derivatives . Option pricing mechanism decoded

Volatility, though a double-edged sword, is often embraced by option traders as it offers more opportunities to make money. The market has been witnessing increased volatility since the virus outbreak, making it a favoured playing field. Not just traders, even investors can use options contract to hedge their portfolio if they sense that the market is in troubled waters. The premium, i.e. the price paid to buy options, will be the cost of hedging.

But it is easily said than done as the option pricing mechanism is not straightforward as, say a futures contract, posing a challenge. Participants who understand how options work is likely to have an edge.

Components of price

The option premium has two components: intrinsic value and extrinsic value.

Intrinsic value is the difference between the price of the underlying asset and the strike price. It has a linear relationship with the underlying, i.e. the intrinsic value goes up if the price of the underlying goes up and vice versa. At the time of expiration, it is only the intrinsic value that remain.

Extrinsic value , also called the time value, is the monetary value associated with the option other than by the price of the underlying. This is the tricky part because this cannot be measured directly like intrinsic value. The time to expiry and the implied volatility are the key factors determining the extrinsic value.

As there is a time component attached, the value of the option erodes as we get closer to expiration even if the price of the underlying remains unchanged. This is referred to as time decay, which is the biggest challenge for buyers. Time decay works in favour of sellers.

Along with this, implied volatility, which measures the market activity, can play a key role. If more action occurs, the implied volatility goes up, driving the option price higher and vice versa. An example can be the time just before a company releases its results. Even if the stock remains flat, the implied volatility can shoot up resulting in wild movement in the price of options as more participants with different expectations come in, increasing the activity.

Thus, the option value does not always change in conjunction with the underlying.

The extrinsic value will become zero at the time of expiration.

Moneyness of options

Moneyness of an option can be said as the measure of how far the strike price of the option is away from the spot price of the underlying. Based on moneyness, options are said to be at-the-money (ATM), in-the-money (ITM) or out-of-the-money (OTM).

An option, be it Call or Put, is considered ATM if the spot price of the security is nearby or equal to the strike price.

A call option is said to be ITM if the spot price of the security is higher than the strike price and OTM if the spot price is lower than the strike price.

A put option is said to be ITM if the spot price of the security is lower than the strike price and OTM if the spot price is higher than the strike price.

Notably, the intrinsic value is zero for ATM and OTM options, whose price are driven by the time to expiry and implied volatility.

Even though OTM and ATM options have no intrinsic value, the price of OTM options are low as ATM options have higher probability of becoming ITM option. The option price increases as it moves from OTM towards ITM.

Option Greeks

Option Greeks are used to measure the sensitivity of the option to various factors. They are Delta, Gamma, Vega, Theta and Rho. Note that, Greeks are not determinants of option price.

Delta tells us the expected change in option price with respect to one rupee move of the security. Call options have positive delta ranging between 0 to 1 whereas put options have negative delta ranging between 0 to minus 1. Gamma denotes the value by which the delta changes for the next one rupee move of the underlying. Simply put, if delta is speed, gamma is acceleration.

Theta measures the effect of time remaining to expiry whereas Vega shows by how much an option price could vary if there is one per cent change in the implied volatility.

Rho is less significant as it measures the change in value of the option with respect to change in interest rate, which are mostly held constant in the pricing mechanism; it barely influences the option value.

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