Understanding Options Contracts with 5 Circles - The Best Stock Market Institute in India

 

By 

THE 5 cIRCLES- BEST STOCK MARKET INSTITUTE IN INDIA- TEAM

 

Updated July 26, 2024

Reviewed by 

VAISHNAVI DIXIT

Fact checked by INVESTOPEDIA

Part of the Series

Ultimate Trading Guide: Options, Futures, and Technical Analysis

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At 5 Circles, India's leading stock market institute, we believe in empowering our students with comprehensive knowledge about financial instruments. Today, we delve into options contracts, a crucial part of the derivatives market.

What Are Options?

Options are derivatives contracts that grant the holder the right, but not the obligation, to buy or sell an underlying asset at a predetermined price before the contract expires. There are two types of options:

• Call Options: The right to buy an asset.
• Put Options: The right to sell an asset.

When you buy or sell an option, you pay or receive an amount called the option's premium. Understanding the valuation of this premium is vital for successful options trading, as it depends on the likelihood that the contract will be profitable at expiration.

Key Components of Option Pricing

1. Intrinsic Value: This is the profit that could be made if the option were exercised immediately. For a call option, it’s the difference between the stock’s current price and the strike price. For a put option, it’s the difference between the strike price and the stock’s current price.

   • Call Option Intrinsic Value = Current Stock Price - Call Strike Price
   • Put Option Intrinsic Value = Put Strike Price - Current Stock Price

   Intrinsic value indicates whether an option is in-the-money (profitable if exercised immediately), at-the-money (strike price equals the current stock price), or out-of-the-money (not profitable if exercised immediately).

2. Time Value: This reflects the potential for additional profitability due to the time remaining until expiration. It’s influenced by the expected volatility of the underlying asset and decreases as the expiration date approaches. The time value is calculated by subtracting the intrinsic value from the option premium.

   • Time Value = Option Premium - Intrinsic Value

   Time value is also referred to as extrinsic value and represents the risk premium required by the option seller to grant the option buyer the rights associated with the contract.

Valuation Models

Several models help determine the fair value of options. These include:

1. Black-Scholes Model: The most widely known model, it calculates the option price by considering factors such as the current stock price, strike price, time to expiration, volatility, and the risk-free interest rate. The formula is:

   $$C = S_t N(d_1) - K e^{-rt} N(d_2)$$

   where:

   • $C$ = Call option price
   • $S_t$ = Current stock price
   • $K$ = Strike price
   • $r$ = Risk-free interest rate
   • $t$ = Time to expiration
   • $N$ = Cumulative normal distribution
   • $d_1$ and $d_2$ are intermediate calculations based on the above variables.

2. Binomial and Trinomial Models: These models create a price tree to evaluate option prices at different points in time up to expiration. The trinomial model is considered more accurate due to its detailed step-by-step approach.

Example: General Electric (GE)

Imagine GE stock is trading at ₹34.80. Here’s how the intrinsic value would work:

• GE 30 Call Option: Intrinsic value = ₹4.80 (₹34.80 - ₹30.00)
• GE 35 Call Option: Intrinsic value = ₹0.00 (not profitable)

Time Value Example

If the GE 30 call option, with one month to expiration, trades at ₹5.00, the time value is ₹0.20 (₹5.00 - ₹4.80). For an option with nine months to expiration trading at ₹6.85, the time value would be ₹2.05 (₹6.85 - ₹4.80).

Volatility’s Impact

The time value is also dependent on the stock’s expected volatility. Higher volatility increases the probability of the option being profitable, thus raising the premium.

1. Historical Volatility: This looks back in time to measure how volatile the stock has been, helping investors decide on the appropriate strike price.
2. Implied Volatility: This is derived from current market prices and indicates the market's expectations for future volatility, impacting the current price of options.

Comparing Stocks

• Low Volatility (GE): GE's beta is 0.49, indicating lower expected price movement. Hence, its options have lower premiums.
• High Volatility (Amazon): With a beta of 3.47, Amazon's stock is more volatile, leading to higher option premiums.

Practical Application

Understanding these concepts is crucial for making informed trading decisions. At 5 Circles, we ensure our students are well-versed in these principles, preparing them to navigate the stock market confidently.

Conclusion

Mastering options trading involves grasping intrinsic and time value, as well as using models like Black-Scholes for valuation. Always seek expert guidance, especially if you're new to investing, to make informed and strategic decisions.

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