Option pricing is a very popular topic for any students studying finance; it can get extremely technical and sometimes divorced from reality. Over the next two articles, my aim is to provide you with the tools to understand how options are priced, and what are the risks involved. Before we begin, let’s briefly recap what options are and how they work.

A call (put) option gives the holder the right, but not the obligation, to buy (sell) an asset at a particular price on a particular date. An example should help clarify this. Silver is currently trading at $17, and an investor buys a 3 month put option on silver with a strike price of $15. This means that the investor has bought the right to sell silver at $15 in three months time. After three months, if silver has fallen below $15, the investor will exercise the option, and make a profit equal to the difference between $15 and the market price. The investor’s net profit will be deducted by the initial premium paid for the option.

Options generally take one of two forms; they are either European or American. A European option allows exercise of the option only on the expiry date, and an American option allows exercise at any time up to and including the expiry date. (Note that European and American are just names, they have no relevance to where these options originate from) In general, it is never optimal to exercise an option prior to expiry, so European and American options will usually behave in the same way. I will explain why this is the case later in this tutorial.

The value of an option can be divided into two components, the intrinsic value and the time value. The intrinsic value is equal to the difference between the strike price and the current market price. Effectively, it is equal to what you would make if you were to exercise the option now. If silver is trading at $17, and we have a call option with a strike price of $14, the intrinsic value of the option is $3. This is because if we exercised the option, we could buy silver at $14, and immediately sell at the current market price of $17, making a profit of $3.

An option will always be in one of three states. These are ITM, ATM, and OTM. (In the money, at the money, out of the money) An ITM option has positive intrinsic value; it is an option that if one were to exercise now, one would make an immediate profit (like in the example in the previous paragraph which had a positive intrinsic value of $3) An ATM option has a strike price equal to the current market price, and this has no intrinsic value. An example would be a silver call option with a strike price of $17, when the current market price is also $17. In general, ATM options are the most liquid. Lastly, an OTM option is one which also has no intrinsic value, and the strike price is not equal to the market price. An example would be a silver call option with a strike price of $20, and a currency market price of $17.

Now let’s move on to time value. The time value of the option is equal to the difference between the current option price and the intrinsic value. For example, a silver call option with a strike price of $15 is trading at $5. The current market price is $17. The intrinsic value is $2 ($17-$15) and the time value is $3 ($5-$2). The time value represents the premium that we pay for the option. As the option approaches expiry, the time value component will decrease, and when the option expires, it will have no time value. As you’d expect, longer dated options have a higher time value. Going back to what I said earlier about European and American options, the reason that it is usually not optimal to exercise an option prior to expiry is that the investor would be giving up the time value. Because an option prior to expiry has positive time value, the market price will always be higher than the intrinsic value. Therefore, an investor is always better off selling the option at the market price rather than exercising it and receiving the intrinsic value.

The determinants of time value can be quite complex. Time value will depend on time to expiry, volatility levels, interest rates, and how far OTM or ITM the option is. We’ll discuss these attributes next week. Next week, we will also discuss the option Greeks (delta, gamma, theta, vega, & rho). This will help to explain how option prices move when other variables move.

A final note before we conclude. Options are often touted as a great way for individuals to invest because they offer unlimited reward and limited risk. This is true, as one can never lose more than the initial premium paid for the option. This
unlimited reward and limited risk comes at a price though. After all, when you buy an option, someone else is selling it to you, and there must be some incentive for them to sell you the option. The greatest enemy of the option buyer is time. Let’s assume you bought a 3 month silver call option with a strike price of $17 for $2, and the current market price is $17. If after the 3 months, the price oscillates but ends up right back at $17, the option will have fallen from $2 to $0, and the investor will have lost $2 despite the price going nowhere. The time value of the option will continually fall until it reaches $0 at expiry. Options are an excellent tool to invest, but always please bear the risks in mind.

*This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits! *

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Aug 18, 2010DineshWhat is the effect of dividend/ bonus/ stock split on options pricing?