Option Valuation

Question :What are the components of Option Value?

Answer :The value of an Option is made up of two components, viz. Intrinsic Value and Time Value.

Question :What is Intrinsic Value?

Answer :The value that you will realize (as a buyer of an Option) on expiry or on exercise is the Intrinsic Value. For example, the Intrinsic Value of a Satyam 280 Call is Rs 11 when the Satyam share itself is quoting at Rs 291. You will realize Rs 11 if you exercise today.

Question :What is Time Value?

Answer :Time Value is the Total Option Value minus Intrinsic Value. For example, if the Satyam 280 Call above is quoting at Rs 25, Time Value will be Rs 25 minus Rs 11 i.e. Rs 14.

Question :How does Intrinsic Value correlate with Share Price?

Answer :In the case of Call Options, higher the Share Price, higher the Intrinsic Value. For example, if Satyam moves up from Rs 291 to Rs 301, the Intrinsic Value has moved up from Rs 11 to Rs 21. There is thus absolute correlation between the two. Obviously, if the Satyam share price moves down, the Intrinsic Value will move down to the same extent.

In the case of Puts, the correlation is absolutely negative. If Reliance is quoting at Rs 300, the Intrinsic Value of a Reliance 320 Put is Rs 20. If Reliance thereafter moves down from Rs 300 to Rs 295, the Intrinsic Value of the Reliance 320 Put will increase from Rs 20 to Rs 25.

Question :How does Time Value correlate with Share Price?

Answer :Time Value does not correlate with Share Price. It correlates with other factors, the principal ones being - Time left for Expiry and Volatility. If Time left for Expiry is high, the Time Value will be higher and vice versa. You will find, for example, that the Reliance 300 Feb Call Option will be cheaper than the Reliance 300 March Call Option. This is because, the March Options will have one more month to expire than the Feb Options.

Interestingly, Time left to expiry affects both Calls and Puts equally. Thus, long term Calls and Puts are priced more than short term Calls and Puts.

Volatility is a very interesting determining factor of Option Value. Higher the Volatility of the share, higher will be the values of both Calls and Puts. This is because, the probability of a highly volatile share moving up or down is much higher than that of a low volatile share. Option values are based on how much movement is possible or expected in the underlying share and higher this possible movement, higher the value of the Option.

Question :Can we summarise the factors determining Option Values?

Answer :

Question :Are there other factors determining Option Values?

Answer :Two other factors which affect Option Values are Interest rates in the economy and Dividends on stocks. These do not affect Option Values significantly. It is expected that higher Interest rates will result in higher Call Option Values and lower Put Option Values. Dividends have the impact of decreasing share prices. Accordingly, Call Option Values will decrease and Put Option Values will increase when Dividends are declared.

Question :How do I know whether a particular Option is correctly priced in the market or not?

Answer :There is a popular Black Scholes Model which provides the theoretical price of Options. Black Scholes Option Calculators are available on various websites. You need to key in the basic parameters which are the following:

• Current Share Price

• Option Strike Price

• Time left for Expiry

• Volatility

• Interest Rate

 Given this data, the calculator will provide you with the price. You can then compare this price with the actual price prevailing in the market and find out whether the Option is being overpriced or underpriced.

Question :Will I face any practical difficulty in this process?

Answer :Yes – you will. You will be able to key in all the above parameters into the Option Calculator except Volatility. This is not clearly known all the time. Further, Volatility can be understood and defined differently by different people. You need to understand Volatility well in order to determine Option Value correctly.

The other factors are clearly known – viz. the Current Share Price, Option Strike Price, Time left for Expiry are frozen anyway. Interest rate estimates can differ from person to person, but Interest rates do not affect Option Values very much, hence this does not matter.

Question :Are there other models also available?

Answer :Yes, there are other models apart from the Black Scholes model. The popular ones are the Binomial Model developed by Cox, Ross and Rubinstein and the Adison Whaley Model. These are slightly more sophisticated than the Black Scholes Model. However, the Option Values are not significantly different. For example, if one Model gives you a Value of Rs 14.12, another might come up with a Value of Rs 14.26. As a retail buyer of Options, you might find that the difference between the bid and the ask at any point of time is probably higher than the differences between Option Values of various Models.

Question :How do I learn about Volatility?

Answer :We will discuss that in our next Article.