How is the price of an option calculated

Published on: Sat Aug 26 2023

The world of financial instruments is vast, with one of the most intriguing being options. At the core of the options market is the concept of option pricing. This article aims to shed light on the intricacies of option pricing and the variables that affect it.

What is an Option?

An option is a financial derivative that provides the holder the right, but not the obligation, to buy or sell an asset at a specified price, known as the strike price, on or before a certain date. Options come in two main types:

Call Option: Gives the holder the right to buy an asset.
Put Option: Provides the holder the right to sell an asset.

Factors Influencing Option Price

Several factors determine the price (or "premium") of an option. Here are the primary ones:

Underlying Asset Price: The price of the asset for which the option exists.
Strike Price: The predetermined price at which the asset can be bought or sold.
Time to Expiration: Duration until the option expires.
Volatility: The degree to which the price of the underlying asset can change.
Risk-Free Interest Rate: The interest rate of a theoretically risk-free investment over the option's life.
Dividends: For stock options, expected dividends can impact option prices.

Time Value and Intrinsic Value

Option premiums can be broken down into two main components:

Intrinsic Value: This is the value derived if the option were exercised immediately. For call options, it's the difference between the underlying asset's price and the strike price. For put options, it's the reverse.
If the current stock price is $105 and the strike price is $100, the intrinsic value of a call option is $5.
Time Value: This represents the value of the time remaining until expiration. As the expiration date approaches, the time value decreases – a phenomenon known as "time decay".
If the option is priced at $7 and the intrinsic value is $5, the time value is $2.

Volatility and Option Price

Volatility plays a significant role in option pricing. More volatile assets are riskier, which affects the option's premium. The two main types of volatilities to consider are:

Historical Volatility: Measures past price fluctuations of the underlying asset.
Implied Volatility: Derived from the option's current price. It reflects market expectations of future volatility.

Greeks in Option Pricing

When discussing option pricing, it's essential to understand "Greeks", which describe the sensitivity of option prices to various factors:

Delta: Measures the change in option price for a $1 change in the underlying asset.
Gamma: Reflects the change in Delta for a $1 change in the asset.
Theta: Measures the option's sensitivity to time decay.
Vega: Represents sensitivity to changes in volatility.
Rho: Denotes sensitivity to changes in the risk-free interest rate.

Conclusion

Option pricing is a blend of art and science, with many factors coming into play. While the Black-Scholes model provides a foundational approach, the real-world considerations of market behavior, sentiment, and unexpected events can also sway prices. Whether you're an investor, trader, or simply a curious mind, understanding option pricing can offer deep insights into the dynamic world of finance.

Returns are subject to market risk.

Past performance do not assure future returns.

Name: Algonauts Advisory Services Private Limited

Registration Number: INA000017277

Type: Non-Individual

Validity: Oct 28, 2022 - Perpetual

Contact Details (Principal Officer):

Mr.Sharad Sankaran:
(Principal Officer)
Algonauts Advisory Service Private Limited:
Email: principal.officer@algonauts.in
Contact Number: +91 8108832455
Address: 1, Dora Rose, I C Colony, Borivali West, Maharashtra, Mumbai 400103.

Contact details of SEBI office:

Office of Investor Assistance and Education, Securities and Exchange Board of India, SEBI Bhavan, Plot No. C4-A, 'G' Block, Bandra-Kurla Complex, Bandra (E), Mumbai - 400 051.

Disclaimer:

Algonauts Advisory Private Limited (Algonauts Advisory Private Limited) is an investment advisor engaged in the equity advisory business. Algonauts Advisory Private Limited is Sebi registered investment adviser. Algonauts Advisory Private Limited Research Analyst SEBI Registration Number - INA000017277. Algonauts Advisory Private Limited SEBI Registration INA000017277.
Recommendation in reports based on technical and derivative analysis centre on studying charts of a stock's price movement, outstanding positions, trading volume etc as opposed to focusing on a company's fundamentals and, as such, may not match with the recommendation in fundamental reports. Investors may visit www.algonautsadvisory.in to view Technical Research Reports.
The information and opinions in this report have been prepared by Algonauts Advisory Private Limited and are subject to change without any notice. The report and information contained herein is strictly confidential and meant solely for the selected recipient and may not be altered in any way, transmitted to, copied or distributed, in part or in whole, to any other person or to the media or reproduced in any form, without prior written consent of Algonauts Advisory Private Limited. While we would endeavour to update the information herein on a reasonable basis, Algonauts Advisory Private Limited is under no obligation to update or keep the information current. Also, there may be regulatory, compliance or other reasons that may prevent Algonauts Advisory Private Limited from doing so.
This report is based on information obtained from public sources and sources believed to be reliable, but no independent verification has been made nor is its accuracy or completeness guaranteed. This report and information herein is solely for informational purpose and shall not be used or considered as an offer document or solicitation of offer to buy or sell or subscribe for securities or other financial instruments. Though disseminated to all the customers simultaneously, not all customers may receive this report at the same time. Algonauts Advisory Private Limited will not treat recipients as customers by virtue of their receiving this report. Nothing in this report constitutes investment, legal, accounting and tax advice or a representation that any investment or strategy is suitable or appropriate to your specific circumstances. The securities discussed and opinions expressed in this report may not be suitable for all investors, who must make their own investment decisions, based on their own investment objectives, financial positions and needs of specific recipient. This may not be taken in substitution for the exercise of independent judgment by any recipient. The recipient should independently evaluate the investment risks. The value and return on investment may vary because of changes in interest rates, foreign exchange rates or any other reason. Algonauts Advisory Private Limited accepts no liabilities whatsoever for any loss or damage of any kind arising out of the use of this report. Past performance is not necessarily a guide to future performance. Investors are advised to see Risk Disclosure Document to understand the risks associated before investing in the securities markets. Actual results may differ materially from those set forth in projections. Forward-looking statements are not predictions and may be subject to change without notice.
Algonauts Advisory Private Limited or its associates might have received any compensation for products or services other than investment banking or merchant banking or brokerage services from the companies mentioned in the report in the past twelve months.
Algonauts Advisory Private Limited encourages independence in research report preparation and strives to minimize conflict in preparation of research report. Algonauts Advisory Private Limited or its associates or its analysts did not receive any compensation or other benefits from the companies mentioned in the report or third party in connection with preparation of the research report.
Accordingly, neither Algonauts Advisory Private Limited nor Research Analysts and their relatives have any material conflict of interest at the time of publication of this report.
Compensation of our Research Analysts is not based on any specific merchant banking, investment banking or brokerage service transactions. Algonauts Advisory Private Limited or its subsidiaries collectively or Research Analysts or their relatives do not own 1% or more of the equity securities of the Company mentioned in the report as of the last day of the month preceding the publication of the research report.
Since associates of Algonauts Advisory Private Limited and Algonauts Advisory Private Limited as a entity are engaged in various financial service businesses, they might have financial interests or actual/ beneficial ownership of one percent or more or other material conflict of interest various companies including the subject company/companies mentioned in this report.
Algonauts Advisory Private Limited may have issued other reports that are inconsistent with and reach different conclusion from the information presented in this report. Neither the Research Analysts nor Algonauts Advisory Private Limited have been engaged in market making activity for the companies mentioned in the report.
We submit that no material disciplinary action has been taken on Algonauts Advisory Private Limited by any Regulatory Authority impacting Equity Research Analysis activities.
This report is not directed or intended for distribution to, or use by, any person or entity who is a citizen or resident of or located in any locality, state, country or other jurisdiction, where such distribution, publication, availability or use would be contrary to law, regulation or which would subject Algonauts Advisory Private Limited and affiliates to any registration or licensing requirement within such jurisdiction. The securities described herein may or may not be eligible for sale in all jurisdictions or to certain category of investors. Persons in whose possession this document may come are required to inform themselves of and to observe such restriction.