Excitedly, Maya turned to Tara and said, “So, Tara, let’s talk about what determines the price of an option. There are several factors at play here, and they all interact to create the overall price. These factors include the current market price of the underlying asset, the strike price of the option, the time remaining until expiration, implied volatility, interest rates and dividends.”
Maya continued, eager to elaborate, “Now here comes the interesting part. All of these factors are combined using mathematical models like the Black-Scholes model or the binomial model to calculate the theoretical value of an option. However , it is important to note that the actual market price of an option may deviate from its theoretical value due to factors such as supply and demand, market conditions and other variables.
Curious to know more, Tara asked, “So, Maya, how exactly do these factors impact option prices, and to what extent?”
Smiling at Tara’s curiosity, Maya replied, “That’s a great question, Tara! We’ll dig deeper into each of these factors and explore their impact one by one.”
Tara leaned in, giving Maya her full attention as she eagerly listened to the further explanations.
1. Current market price of the underlying asset:
Continuing her explanation, Maya explained to Tara, “When it comes to pricing an option, the current market price of the underlying asset is the key factor. call options (right to call), when the market price of the underlying asset rises, the value of the call option generally follows suit. Conversely, for put options (right to put), when the market price of the underlying asset falls, the value of the put option generally increases.”
2. Option strike price
Maya continued, “Now let’s talk about the strike price. The strike price of the option is another important factor to consider. In general, the closer the strike price is to the current market price of the option. underlying asset, the higher the option price. This is because options with strike prices closer to the current market price have a higher probability of being “in the money”, which means they are more likely to be profitable and therefore more valuable.
“What does ‘In the Money’ mean?” Tara asked curiously.
Maya quickly responded by saying, “Well, at any given time, an option with a specific strike price can be classified into one of three key states: in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM). These states depend on the relationship between the strike price of the option and the current market price of the underlying asset.
Maya continued to provide more information saying, “Let’s break down the value of an option into two parts: intrinsic value and extrinsic value. When an option is in-the-money (ITM), it means that the option holds both intrinsic and extrinsic value.
However, for ATM and OTM options, there is no intrinsic value present.”
In the Money (ITM):
To go further, Maya gave an example by saying: “Consider a call option on Addiction stock with a strike price of 2200, while Reliance’s current market price is 2400. In this scenario, the call option is classified as ITM because the market price exceeds the strike price. The intrinsic value of the option is 200, which is the difference between the market price and the strike price (2400-2200).”
Maya emphasized the importance of a call option, explaining, “Remember that a call option gives you the right to buy Reliance at the strike price. In the case of call options ITM, traders can choose to exercise the option and buy the underlying stock at the strike price of 2200. They can then sell it at the higher market price of 2400 resulting in a profit of 200, which represents the intrinsic value of the ITM option. Additionally, as Reliance prices continue to rise, your profit will increase as the intrinsic value of your ITM 2200 exercise call option increases. increase.”
Gaining clarity on ITM calls, Tara further asked, “I understand. So would it be the opposite in the case of ITM puts?”
Maya responded enthusiastically, saying, “Absolutely! Put options work the opposite of call options in that they give you the right to sell instead of buy. When it comes to put options, being “in the money” means that the market price is lower than the strike price. Let me give you an example. Suppose you have a put option for Reliance with a strike price of 2,500, and the current market price of Reliance is 2,400. In this case, the put option is “in the money”. ‘ (ITM) because the market price is lower than the strike price. The intrinsic value of this option would be 100, which reflects the difference between the strike price and the market price (2500 – 2400).”
Maya went on to explain, “As you may recall, a put option grants the put buyer the right to sell at the strike price. So with your ITM put option, you can choose to to exercise it, by selling Reliance at the strike price of 2500 after buying it in the market at the current price of 2400. This would result in a profit of 100, which is equal to the intrinsic value. ITM put options, you can now see that if Reliance prices fall even further, your profit will increase, primarily due to the increase in the intrinsic value of your ITM option.”
Tara expressed her gratitude saying, “It’s very clear now. Thank you for explaining ITM in detail. What about ATM and OTM options?”
Chart: call option
Maya quickly replied, “When an option is ‘at the money’ (ATM), it means that the strike price is approximately equal to the current market price of the underlying asset. Consider both an option d call and a put option on Reliance with a strike price of 2400, while the current market price of Reliance is also 2400. In this case, the call and put options are both ATMs Although they have no intrinsic value, they can still have extrinsic value, which is often called time value.”
Maya went on to explain, “This time value becomes important and traders often consider factors such as time to expiration, implied volatility and market expectations when dealing with ATM options. engaging in strategies such as straddles or chokes, which involve buying a call option and a put option simultaneously at the same strike price to take advantage of potential price fluctuations. ask the question, let me clarify that we will cover many of these strategies in detail later.
“Okay,” Tara replied with a smile, feeling more confident and excited about the discussions to come.
Out of Money (OTM):
Maya continued the conversation by saying, “Now let’s focus on call options with strike prices above the current price of 2400. These options are called ‘out of the money’ or OTM. Exercising them would result in a loss, so you have a choice not to exercise them (no obligation), and most of them will expire worthless if prices do not move significantly to make these OTM options “in the money” or ITM. “
“Similarly, when it comes to putting all put options below the current price, they are considered ‘out of the money’ or OTM put options, which only hold extrinsic value. The price of the underlying asset would have to drop significantly for those OTM options to be worth exercising after gaining intrinsic value to become “in the money” or ITM.”
Tara inquired enthusiastically, “So when it comes to buying OTM options, what are the chances of them turning into profitable investments?”
Maya then explained the risks of buying OTM options, especially distant OTM options with lower premiums, for speculative purposes.
She said: “Buying OTM options, especially far OTM options, for speculation is like playing the lottery with the odds against you. Not only do you need a favorable move, but that move must occur within a limited time for your OTM options to become ITM. If the reverse movement occurs or even if prices remain stagnant, your OTM option will expire worthless, resulting in a loss of the premium paid. Even if a favorable movement occurs product but is not enough to exceed your strike price and make your option OTM ITM, you would still lose the entire premium.”
“That makes sense,” Tara replied, seeking further clarification, “but if OTM options are like the lottery, there has to be someone profiting from selling those options, right? “
“You’re absolutely right,” exclaimed Maya. “Far OTM options are a delight for option sellers. However, writing options without any hedging or strategy carries unlimited risk. Even though the odds are in their favor most of the time, sometimes a large move and rare against them can wipe out their account.”
Tara asked for further clarification saying, “Can you please explain this to me?”
Chart: Profits and Losses
“Certainly,” Maya replied. “For option buyers, they have rights but no obligations. Their maximum loss is therefore limited to the premium they have paid. In the event of an adverse move, they simply choose not to exercise the option and lose the However, if there is a favorable move, the potential for unlimited profits exists as the price can continue to move favorably for an extended period. On the other hand, for option sellers, there is an obligation So if prices continue to move against them, there is no limit to their losses, and their maximum profit is limited to the premium paid by the buyer of the option. Option sellers’ high probability of gain translates into unlimited risk and limited profit potential.
Tara considered the pros and cons, then asked, “So buying and selling options has its own issues. How should options be traded?”
Maya replied, “By using multiple options, we can create strategies that provide a balance between probability of gain and risk-reward. We will discuss these strategies once we are done with the factors that affect commodity prices. options. However, since we have covered the most important factor, which is the price of the underlying asset, I think now is a good time to introduce you to Greek options along the way.”
“What is the Option Greeks,” Tara asked curiously.
Maya replied “Greek options are parameters used to measure the sensitivity of options to various factors such as changes in the price of the underlying asset, changes in volatility, decay over time and interest rates. interest. These parameters are used to assess and manage the risk associated with option positions. There are five main Greek options: Delta, Gamma, Theta, Vega and Rho.”
TO BE CONTINUED…
(The author, Sovit Manjani, is the CEO of Yubha.com, TradingHeads.com)