Understanding Methods To Value an Option

Envision yourself in a bustling bazaar, encircled by vendors negotiating over merchandise. You notice something special among them: possibilities. The potential for gains or losses depending on future asset movements is provided by these financial tools. But amid all this commotion, how do traders determine the value of these options?

Options valuation is similar to solving a riddle in finance. It requires a little amount of intuition, market knowledge, and arithmetic. In the intricate world of financial markets, traders and investors need to understand how to price options. Now let's examine how options are valued and discover what influences their prices.

Option Pricing

Option pricing refers to the process of determining the fair market value of an option contract. It grants the holder the right to buy or sell an underlying asset at a predetermined price within a specified timeframe. 

Before we dive into the various methods of option valuation, let's take a closer look at the fundamental principles behind option pricing. 

Intrinsic Value

Intrinsic value is a concept in finance that's like the real, tangible worth of something. It's the actual value that you can see and touch, not just what someone says it's worth.

The intrinsic value of a call option is calculated as the difference between the current market price of the underlying asset and the strike price. If the market price exceeds the strike price, the call option possesses intrinsic value. Otherwise, its intrinsic value is zero.

Conversely, the intrinsic value of a put option is determined by the difference between the strike price and the current market price of the underlying asset. If the market price falls below the strike price, the put option holds intrinsic value; otherwise, it has no intrinsic value.

Intrinsic value serves as a critical determinant in crafting option trading strategies tailored to capitalise on market opportunities.

• In-the-Money Options: Options with intrinsic value are described as "in the money" (ITM). Traders often utilise ITM options to execute bullish or bearish strategies, depending on whether they hold a call or put options, respectively.
• Out-of-the-Money Options: Conversely, options lacking intrinsic value are referred to as "out of the money" (OTM). While OTM options may initially appear less attractive due to their lack of intrinsic value, they offer the potential for substantial gains if the underlying asset's price moves favourably before expiration.

Let's say you're considering buying a call option for shares of a company listed on the Indian stock market. The current market price of the stock is ₹150 per share. You're looking at a call option with a strike price of ₹140 per share, and the option premium (the price you pay for the option) is ₹15.

Here's how intrinsic value would be calculated for this call option:

Intrinsic Value = Current Stock Price - Strike Price

Intrinsic Value = ₹150 - ₹140 = ₹10 per share

So, each share of the stock has an intrinsic value of ₹10.

Now, let's say you decide to buy this call option. If you exercise it right away, you could buy the stock at the strike price of ₹140 (because that's what the option contract allows) and then immediately sell it in the market for ₹150 (the current market price). This would give you a profit of ₹10 per share (₹150 - ₹140), which is exactly the intrinsic value of the option.

However, you also paid a premium of ₹15 for the option. So, while the option has an intrinsic value of ₹10, you actually paid ₹15 for it.

Understanding the intrinsic value helps you assess whether the option is a good deal or not, and it's crucial for making informed trading decisions in the Indian stock market.

Extrinsic Value

Extrinsic value is like the bonus value of an option beyond what you can see from the stock's current price and the strike price. It's the part of the option's price that comes from factors like time and how much people think the stock price might change.

It is the portion of an option's premium that exceeds its intrinsic value. Extrinsic value reflects the market's expectation of potential future price movements of the underlying asset and the uncertainty associated with it. As options approach expiration, their extrinsic value diminishes, eventually reaching zero at expiration.

In simple terms:

Extrinsic Value = Option Price - Intrinsic Value

Let’s understand it with an example. Suppose a call option with a strike price of ₹50 has a premium of ₹8. If the intrinsic value of the option is ₹5, the remaining ₹3 of the premium represents its extrinsic value.

The extrinsic value of an option is based on a combination of the following factors:

• Time Value: 

This is like how much time is left before the option expires. The more time you have before the option expires, the more chances there are for the stock price to move in a favourable direction. So, options with more time until expiration have more extrinsic value.

Imagine you're considering buying a call option for shares of a popular Indian company. The current market price of the stock is ₹500 per share, and the strike price of the call option is also ₹500 per share. However, there's a catch—the option you're looking at expires in one month.

Now, let's say there's another call option for the same company with the same strike price of ₹500, but it expires in six months instead of one. Even though both options have the same intrinsic value (zero because the strike price equals the current market price), the option with six months until expiration would likely be more expensive.

Why? Because the longer expiration date provides more time for the stock price to potentially move in a favourable direction. Traders are willing to pay extra for the additional time, which adds to the extrinsic value of the option.

• Volatility Value:

This is how much people think the stock price might change. If there's a lot of uncertainty or excitement about the stock, the option might be worth more because there's a higher chance it could become valuable before it expires. So, options for stocks that are expected to have big price swings have more extrinsic value.

Suppose there's a company known for its unpredictable stock price movements. This company is about to announce its quarterly earnings, and there's anticipation in the market about whether the earnings will exceed or fall short of expectations.

For call options on this volatile stock, even if the strike price is the same as the current market price, options expiring after the earnings announcement might be priced higher than those expiring before. This is because there's an expectation of increased volatility around the earnings announcement, which could potentially make the option more valuable.

The uncertainty and excitement surrounding the stock's price movements contribute to higher extrinsic value for options expiring during periods of expected volatility.

• Demand:

If the number of traders looking to buy an option at a specific price outweighs the number of sellers, the value of that option tends to rise. This imbalance in supply and demand is a common occurrence, especially in trending markets.

Let's consider a scenario where a significant number of traders are interested in buying call options for a specific stock that's rumoured to be a potential takeover target. This sudden surge in demand for call options could drive up their prices, even if the intrinsic value remains unchanged.

For example, if the strike price of the call option is lower than the rumoured takeover price, traders would be willing to pay a premium for the option due to the increased demand. This premium above the intrinsic value reflects the extrinsic value attributed to the potential opportunity associated with the takeover speculation.

This scenario illustrates a key challenge faced by option buyers: the potential to be correct in market direction while still incurring losses. 

In equity indices, the implied volatility of at-the-money options is typically lower than that of out-of-the-money options, leading to a negatively skewed volatility profile. This tendency is particularly pronounced for distant strike-price put options. 

It's essential to distinguish between implied volatility and market volatility (historical volatility). While market volatility measures actual price movements, implied volatility reflects the option premium itself. This means that options with different strike prices or expiration dates but based on the same underlying asset may exhibit varying levels of implied volatility. 

Understanding extrinsic value helps you see why some options might be more expensive than others, even if they're for the same stock and have the same strike price. 

Bottom Line

In this chapter, we've explored the basics of option valuation, diving into the concepts of intrinsic and extrinsic values, and introduced the significance of option Greeks. This knowledge is essential for anyone looking to engage with options in the financial markets.

Moving ahead, our next chapter will focus on the Impact of Option Greeks and the Methods Used to Value Options. We'll examine Delta, Gamma, Theta, Vega, and Rho in greater detail to understand their influence on option prices. Additionally, we'll revisit valuation methods like the Black-Scholes Model, Binomial Pricing Method, and Monte Carlo Simulation with a practical approach. This next section aims to enhance your strategies and decision-making in options trading, providing a deeper insight into how options are priced and how to use this information effectively.