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Chapter 8: Options Valuation


Options valuation is a critical aspect of options trading, as it helps traders determine the fair price of an option contract. Accurate valuation enables traders to make informed decisions, maximizing profits and minimizing risks. Here are the key components and methods used in option valuation:

Intrinsic Value

Intrinsic value is the inherent worth of an option. It represents the difference between the underlying asset’s current price (spot price) and the option’s strike price.

  • Call Option: Intrinsic value is calculated as the spot price minus the strike price. If the result is positive, the option has intrinsic value; otherwise, it is zero.
  • Put Option: Intrinsic value is calculated as the strike price minus the spot price. If the result is positive, the option has intrinsic value; otherwise, it is zero.

Example:

  • If a call option has a strike price of $50 and the underlying stock is trading at $60, the intrinsic value is $10.
  • If a put option has a strike price of $50 and the underlying stock is trading at $40, the intrinsic value is $10.

Time Value

Time value reflects the additional amount traders are willing to pay for an option above its intrinsic value. It accounts for the potential of the option increasing in value before expiration. The longer the time until expiration, the higher the time value.

Factors Influencing Time Value:

  • Time to Expiration: More time increases the probability of favorable price movements.
  • Volatility: Higher volatility increases the likelihood of significant price changes, raising the option’s value.
  • Interest Rates: Changes in interest rates can affect the time value, particularly for longer-term options.
options premium time value decay

Option Pricing Models

Several models are used to calculate the fair value of options, incorporating both intrinsic and time values. The most commonly used models include:

  • Black-Scholes Model: This model calculates the theoretical price of European call and put options, assuming constant volatility and interest rates. It uses factors like current stock price, strike price, time to expiration, risk-free rate, and volatility.
  • Binomial Model: This model uses a tree of possible future stock prices to evaluate American options, which can be exercised at any time before expiration. It considers the possibility of different price paths the stock could take.

Factors Affecting Option Prices

Several factors influence option prices, making them dynamic and sensitive to market conditions. Key factors include:

  • Underlying Asset Price: Changes in the price of the underlying asset directly affect the option’s value.
  • Strike Price: The relationship between the strike price and the underlying asset’s current price determines the intrinsic value.
  • Time to Expiration: Options lose value as they approach expiration, a phenomenon known as time decay.
  • Volatility: Higher volatility increases the potential for significant price movements, raising the option’s value.
  • Interest Rates: Rising interest rates typically increase call option prices and decrease put option prices.
  • Dividends: Expected dividends on the underlying asset can impact option prices, especially for longer-term options.
CauseCall Value (Buy)Put Value (Sell)
Asset value increasing Rise Fall
Strike price increasing Fall Rise
An increment in underlying asset price fluctuation Rise Fall
An increment in options expiry time Rise Rise
Stocks dividend amount increases Fall Rise
An increment in interest rate Rise Fall

Conclusion

Understanding option valuation is essential for successful options trading. By considering intrinsic value, time value, and various pricing models, traders can make informed decisions about buying and selling options. This knowledge helps in maximizing returns and effectively managing risks.

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Chapter 9: Options Trade Settlement
Chapter 10: Options Greeks
Chapter 11: Options Strategies
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