Options Pricing
There are two major components of the option’s premium; these are the intrinsic and the time value.
For the Intrinsic Value (also termed Calls); a call option is considered to be in-the-money when the price of the underlying security is above the said strike price.
For the Intrinsic Value (Puts); a put option is called as in-the-money if the price of the underlying security is below the given strike price.
In-the-money has intrinsic value, which represents the disparity between the underlying security’s present price, and the price of the option exercise (strike amount or price).
The Time Value of Options Pricing
Before expiration, a premium which is in surplus with intrinsic value is known as time value.
Also, the time value is also referred to as an amount which the investor wants to pay money for a given option more than the intrinsic value, hoping that there may likely be a time that such options’ value will be higher prior to its expiration.
The time value is greater if the period of time for the market situations to favor an investor is longer.
Options premium are influenced by major factors such as;
- The underlying security’s price change
- The period or time pending expiration
- Strike price
- Risk-free interest rate/Dividends
- The underlying security’s volatility
Among these major factors outlined above, Risk-free interest rate/Dividends have the least effect on options premium.
The value of options can be increased or decreased by changes in the price of the underlying security price. These changes in price exert counter effects on the Calls and Puts.
Here’s an example; with the rise in the underlying security’s value, a Call typically gets higher, and a Put’s value will typically get lower in price. Generally an opposite effect will be experienced when there is decrease in the value of the underlying security.
If an Option has an intrinsic value, it will be determined by the strike price. This strike price also spells out if or not one option has no intrinsic value. The premium of an Option (which is intrinsic value + time value) typically gets higher as options get more in-the-money, and gets lower as Options substantially get further out-of -money.
An option premium’s time value component is affected by time until the expiration. Usually, with the nearing of expiration, an option’s time value levels declines or erodes for both the Puts and Calls. This is mostly conspicuous for the at-the-money options.
The most subjective as well as probably the most challenging aspect to quantify is the effect of volatility; nevertheless, it is capable of exerting substantial impact on an option’s premium time value aspect.
Simply, volatility is the measure of uncertainty (risk), or the variability of an option’s underlying security price. When volatility estimates are higher, it simply shows greater anticipated fluctuations in the price levels of the underlying security.
An underlying security’s dividends effect along with the present risk-free interests rate exert little but measurable impact on the premiums of options.
Category: Option Pricing
