Options, one of the most common derivative instruments, can be full of surprises. That’s the reason pricing of options is one of the most challenging jobs. However, we have different pricing models, which try to bring some order in an otherwise chaotic world of options. But these models use complicated equations which are beyond the reach of our friend Johnny. So let’s try to learn, in the language of a newbie, what goes into the pricing of options.
Jinny: Hi, Johnny! I see you are in a lighter mood. What’s up?
Johnny: I remain in a lighter mood whenever I am thinking about something serious.
Jinny: Really? Can I also join?
Johnny: Of course, you can. In fact, I was just wondering whether we can make a mathematical model for catching a fish. I am sure if we are ever able to make such a model, it would not be as complicated as some of our options pricing models. What do you say?
Jinny: Well, I can’t talk much about models for catching fish, but I can surely explain how options are priced without going into complicated details of models, if that is what you want to understand.
Johnny: That’s right, Jinny. But let’s get into the basics first.
Jinny: Options, as you know, are contracts in which the option buyer acquires the right but no obligation to buy from or sell to the option seller the underlying asset at a predetermined price called “strike price”. Options that give the right to buy are called “call options” and options that give the rights to sell are called “put options”. Further, options can be classified as “European options”, which can be exercised only on the expiry date, and “American options”, which can be exercised on or any day before the expiry date. As if these two were already not enough, we also have “Bermuda options” and “Asian options”, which we will ignore for now to avoid confusion.
In options of any kind, the option buyer is under no obligation to exercise his option. However, once he chooses to do so, the option seller is bound to honour his promise. To avail this kind of one-way ticket, the option buyer has to pay a price called “option premium” to the option seller.
Now, we come to the crucial part. How do we decide the option price that is good enough to induce the option seller to undertake all the risk? Well, we can use any of the option pricing models such as the Black Scholes model or Binomial option pricing model or any one of the other variants for determining the option premium. These models no doubt use complex mathematical equations that look very intimidating to beginners. But once you understand their basics, you can use them like playthings.
Illustration: Jayachandran / Mint
Johnny: So far, so good. Tell me, Jinny, how is the price of an option determined?
Jinny: The pricing of an option revolves around two components—one is called the “intrinsic value” and the other is called the “time value”. “Intrinsic value” represents the true worth of your option at present. This value does not remain constant but keeps changing over the life of your option. In fact, its value may fluctuate between zero and infinite positive numbers.
What, you may wonder, if the intrinsic value gets into negative territory? Well, an option having intrinsic value in negatives is only as bad as an option having zero intrinsic value. Why? That I will explain in a while. Just keep in mind that at worst you can lose the bird in hand. You can’t lose more than what you actually had.
Johnny: How can we find out the intrinsic value of an option?
Jinny: For finding out the intrinsic value, there is no need to use complex mathematical equations. You simply need to find out whether the strike price of the underlying asset of your option is higher or lower than its current market price.
For a call option, a strike price lower than the current market price means you can buy the underlying asset at a lower price than the current market price by exercising your option. Such options have a positive intrinsic value which you can find out by subtracting the strike price from the current market price.
Suppose you hold a call option for buying a single share of company X at a strike price of Rs100 per share before the expiry date and the same share is presently trading at a higher price of Rs120. The intrinsic value of the present option is Rs120 minus Rs100, or Rs20. The benefit of such a situation is obvious. You can earn a profit of Rs20 by exercising an option having an intrinsic value of Rs20. In technical terms, we can also say that your option is “in the money” by Rs20.
Johnny: But what if the strike price of the call option is higher than the current market price?
Jinny: Well, that’s something you can think about till we meet next week.
What: The price of an option or option premium consists of “intrinsic value” and “time value”.
How: We can know the intrinsic value by comparing the current market price of the underlying asset with its “strike price”.
When: A call option is “in the money” when the strike price of the underlying asset is lower than its current market price.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at firstname.lastname@example.org