Tuesday, February 15, 2011

Options Trading In India - Part IV

What is the Intrinsic Value of an option?

The intrinsic value of an option is defined as the amount by which an option is in-the-money, or the immediate exercise value of the option when the underlying position is marked-to-market.

For a call option: Intrinsic Value = Spot Price - Strike Price

For a put option: Intrinsic Value = Strike Price - Spot Price

The intrinsic value of an option must be a positive number or 0. It cannot be negative. For a call option, the strike price must be less than the price of the underlying asset for the call to have an intrinsic value greater than 0. For a put option, the strike price must be greater than the underlying asset price for it to have intrinsic value.

Time Value with reference to Options.
Time value is the amount option buyers are willing to pay for the possibility that the option may become profitable prior to expiration due to favorable change in the price of the underlying. An option loses its time value as its expiration date nears. At expiration an option is worth only its intrinsic value. Time value cannot be negative.

What are the factors that affect the value of an option (premium)?

There are two types of factors that affect the value of the option premium:

Quantifiable Factors:

underlying stock price,

the strike price of the option,

the volatility of the underlying stock,

the time to expiration and;

the risk free interest rate.

Non-Quantifiable Factors :

Market participants' varying estimates of the underlying asset's future volatility

Individuals' varying estimates of future performance of the underlying asset, based on fundamental or technical analysis

The effect of supply & demand- both in the options marketplace and in the market for the underlying asset

The "depth" of the market for that option - the number of transactions and the contract's trading volume on any given day.

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