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The Indian financial industry serves professional traders and investors an income to make their living. So, these investors must choose investments that ensure maximum profits. So, are you a professional trader? For you, two things are extremely important.
One is value investing via equities, and another is short-term profit that comes with options trading. Welcome to this all-encompassing post that helps you understand the importance of intrinsic value and time value of options trading. So, before embarking on this investment journey, you must understand these aspects.
An overview of options
These are contracts of two significant types: while one is the call option, another is the put option. In simple words, the call option is the contract under. It is an option buyer who purchases the right to get assets from option sellers at the strike price on a certain day. This day is the expiry day).
On the other hand, the put option is a contract where option buyers purchase their right to sell assets to the option-seller. It occurs at a certain price (which is the strike price) on a specific day. This option buyer must pay the premium to the option seller.
Premium of an Option’s value depends on the supply and demand. Here’s the formula:
Option premium = Time Value + Intrinsic Value
Understanding the intrinsic value of options
A trader’s choice of buying entirely depends on the profit they wish to make. And the difference between the spot price and the strike price is the profit option. Buyers can make it if they hold an option until maturity. Understanding the difference between the spot price and the strike price of the asset helps the investor make a well-informed decision. This notional profit demonstrated by the difference is better termed the intrinsic value of options. It’s the simplest calculation. The formula is:
Intrinsic value of call option = The Spot Price – The Strike Price Intrinsic value of put option (= The Strike Price – The Spot Price)
Outlining the time value of options
So, how to calculate time value of option? Simply put, the value of the option is the additional money the purchaser is willing to pay over this value until the date of expiry. Suppose the options contract is far away from the expiry date. There are chances for buyers to make it “in-the-money” or toward a direction.
The more the amount of time available for the market conditions to work to the benefit of investors, the greater the time value. In short, the time value is the extrinsic value since other parameters influence the option’s premium outside of the intrinsic value. Here’s the time value of the option formula:
Time Value = Option Premium – Intrinsic Value
Managing the risks with intrinsic and extrinsic values: things to follow
Suppose the option buyer, Mr X, wants to purchase the option from Ms Y. He has to decide on buying the call option. The most excellent way to evaluate this is by understanding whether he should trade the option. It can be assessed by demonstrating whether the premium will rise or fall.
Let’s say that the option premium is supposed to increase. In such a situation, Mr X can purchase the option at ₹30 and later on sell it at ₹40. So, Mr. T can get a profit of ₹10. Note that the time value is expected to reduce with time. So, that makes it evident that the intrinsic value will rise. So, how would Mr. X anticipate whether the option premium will increase or not? By assessing the following parameters, it becomes easier to determine the rise or fall of the option premium:
Technical analysis
In simple language, depending on technical analysis helps gauge the way the asset’s price will shift. It helps anticipate the option’s intrinsic value. One can predict the spot price, which is the strike price under the contract. There are several tools that help you with technical analysis.
News analysis
Stock prices will change because of actual events in the market. However, perception of the same events among retail and institutional investors also determines the stock prices. Thus, it is imperative to keep a note of the news and assess the analysis.
Implied volatility
Also termed IV, implied volatility refers to the expected stock price’s volatility during the option contract’s life. A higher IV means the stock’s price will also be higher. It further increases during the period until its expiration date.
You can evaluate the above metrics to decide whether you can trade the option or not.
Dividends and interest rates in pricing options
The fluctuation of the interest rate and dividends also influences options’ prices. Interest rates can indeed affect the options pricing. However, the change is low compared to changes due to market volatility. Increased interest rates may result in rising call premiums and lower put premiums. Changes to interest rates affect the option valuation.
Dividends impact the option premium via the impact on underlying stock prices. The share price may also be impacted if the stock trades without the value of the dividend payment.
FAQs
An investor can learn about the current time value of the option just by subtracting the difference between the strike price and the spot price from the premium. One can anticipate changes in time value by using the value for calculating the time decay.
Time and intrinsic value comprise the major portion of the option premium, depending on the time. So, it is quite challenging to state which is more important. Thus, it can be stated that both have equal values in option trading.
In accordance with the intrinsic value, an investor needs to remember one thing. If two options are losing your money, the intrinsic value would be constant at zero (for both of them). So, identifying the negative potential of the option from this value is a challenging task.
The value keeps on changing based on different parameters. So, the chances of the options are more profitable. So, the option’s time value may reduce and result in a fall in its premium. This phenomenon is better referred to as time decay.
The option time decay formula is
Time decay = (Stock price – Strike price) / the number of days until the expiry date
The following are the factors that have a great impact on the options premium:
Strike
Underlying price
Implied volatility
Time until the expiry date
Interest rate
Dividends
Suppose in a fiscal year, the trader finds a company that may have strong fundamentals coupled with cash flow opportunities. So, it trades ₹10 per share, and the intrinsic value is closer to ₹15 for each share. Then, a bargain of ₹5 may occur.