Options Pricing and Factors Affecting Option Premium
You wish to watch the first day, first show of a blockbuster movie set to release next month. Given the huge anticipation for the movie, you fear the tickets might sell out. Here is something you can do to ensure you do not lose out. You pay a small non-refundable amount, say ₹100, upfront to the ticket-selling platform to reserve your ticket.
In case you fail to turn up for some reason, your loss is limited to ₹100 only. And, if you are able to catch up with the movie, the upfront price ensures your seat is not lost. In the derivatives world, option premiums work in a similar way. How? Let us find out.
What is Option Premium?
Option premium, or option pricing, is the price you pay to the seller for the right to buy or sell an underlying asset (such as stocks, gold, currency, etc.) at a specific price in the future. In other words, it is the amount you need to pay the seller to exercise or acquire the rights under the option. The option premium, much like the amount you pay to reserve your seat for the movie, is non-refundable.
Option premiums are priced per share and apply to lots of shares, known as lot sizes. Lot size is the minimum number of shares available in a single lot.
Let us understand it with an example. Suppose the option price of a certain stock is available at a premium of ₹20 per share. The lot size is 100 shares. To exercise the option, you need to pay a premium of ₹2000 (20 × 100).
This is a simple way for calculating option premium amount, which is the premium per price multiplied by the lot size.
Factors Affecting Option Premium
The option premium is not constant, with several factors affecting it. These include:
Time to Expiry
Every option has a certain expiry date, much like the daily items we use. Option premium is directly proportional to the time to expiry. It means the higher the time to expiry, the greater the option premium. Now, you may ask, why? This is because a longer time frame gives the stock price more time to move in your favour.
For example, a 30-day option premium is more expensive than a 2-day option premium. This is because many things can happen within 30 days. Markets could become more volatile, the company could announce major results, and a lot more. However, there is a lower chance of such things happening in the 2 days.
Volatility
Volatility plays a vital role in determining the option premium amount. Stock markets are volatile. However, volatility does not affect every stock price in the same manner. While some may experience rapid highs and lows, others may remain steady. If a stock’s price experiences high volatility, unpredictability goes up. In such a scenario, there is a greater chance of profiting from price swings. Thus, options premiums increase.
For instance, if a stock’s price moves up or down by, say, ₹10 due to volatility, the option premium for it may be low. On the other hand, if a stock’s price moves up or down by ₹100 due to volatility, the premium can be high.
Value of Underlying Assets
Options derive their value from underlying assets. These could be gold, currency, etc. When the price of underlying assets changes, the option premium also changes. When the price of the underlying asset rises, the call option price rises, while the put option price falls. Why? Because in a call option, you have the right to buy at a fixed price. On the other hand, in a put option, you have the right to sell at a fixed price.
In a rising market, your right to buy becomes more valuable. Thus, the call option premium is high. On the contrary, in a rising market, the right to sell becomes less useful. This drags down the put option pricing.
The situation is exactly the opposite when the price of underlying assets goes down. In such a scenario, the call option price goes down. The put option price goes up. As in a falling market, your right to buy is not that helpful, the call option price goes down. However, the right to sell becomes more valuable. Therefore, the put option becomes expensive.
Conclusion
Understanding how options premiums work and the factors that affect them can help you make informed decisions. It also helps you better understand options and navigate them with confidence.
Sources:
This article is for informational purposes only and does not constitute financial advice. It is not produced by the desk of the Kotak Securities Research Team, nor is it a report published by the Kotak Securities Research Team. The information presented is compiled from several secondary sources available on the internet and may change over time. Investors should conduct their own research and consult with financial professionals before making any investment decisions. Read the full disclaimer here.
Investments in securities market are subject to market risks, read all the related documents carefully before investing. Brokerage will not exceed SEBI prescribed limit. The securities are quoted as an example and not as a recommendation. SEBI Registration No-INZ000200137 Member Id NSE-08081; BSE-673; MSE-1024, MCX-56285, NCDEX-1262.
