How Is The Premium Of An Options Contract Calculated

Options contracts are a common tool for traders and buyers in the Indian stock market. Understanding how options premiums are calculated helps in gaining insights into the derivatives market. This piece is mostly about how to figure out the option price and lists the most important factors that go into that. Keep reading!

Contents

• Components of Option Premium
  • Intrinsic Value
  • Extrinsic Value
• Evaluating Intrinsic Value
  • For a Call Option
  • For a Put Option
• Calculating Extrinsic (Time) Value
• Application of Pricing Models
  • Black-Scholes Model
  • Binomial Model
• Conclusion
• FAQs

Components of Option Premium

An option premium is the amount of money paid to get the rights of an options contract. It has two parts:

Intrinsic Value:

The instant, real gain of exercising the choice is its intrinsic value. For a call option, intrinsic value is calculated as the difference between the current price and the strike price if the current price is higher. For a put option, on the other hand, the difference between the strike price and the present price is its intrinsic value. That is when the strike price is higher than the market price. An option’s intrinsic value is zero if it is “out of the money.”

Extrinsic Value:

Extrinsic or time value represents the extra premium above the intrinsic value. This value shows the possibility of gaining intrinsic value before expiration. Factors such as the time left until expiration, the instability of the underlying asset, and current interest rates add to the extrinsic component. Even when an option lacks intrinsic value, its extrinsic value may still be significant due to the chance of positive price changes in the future.

Also Read: What Are Index Funds And Why Are They Popular?

Evaluating Intrinsic Value

When you activate an option right now, the intrinsic value shows how much you will gain immediately. To find out, do the following:

For a Call Option:

• Formula: Intrinsic Value = Current Price of Underlying Asset – Strike Price
• Condition: Just when the current price is higher than the strike price, the intrinsic value increases. If not, there is no intrinsic value.

For a Put Option:

• Formula: Intrinsic Value = Strike Price – Current Price of Underlying Asset
• Condition: The intrinsic value is positive when the strike price is higher than the present price. If not, it’s equal to 0.

Calculating Extrinsic (Time) Value

Time value is another name for the extrinsic value. As a result of the possibility of future movement, buyers are willing to pay more than the asset’s intrinsic value. To figure it out, we use:

Formula: Extrinsic Value = Option Premium – Intrinsic Value

Application of Pricing Models

Traders use models that include key factors to create a potential premium. The Black-Scholes model is commonly used for pricing European options, while the Binomial model is used for both European and American options. Let’s look at the steps these models take to calculate.

Black-Scholes Model:

If you want to price European options, you mostly use the Black-Scholes model. Its method for a call option looks like this:

C = S · N(d₁) − X · e^(–rT) · N(d₂)

Here:

• S is the price of the base object at the moment,
• The strike price is X.
• T is the time left until the end (in years),
• The risk-free interest rate is r and
• The functions N(d₁) and N(d₂) show the total distribution for a normal distribution.

The numbers d₁ and d₂ come from the logarithmic relationship between the product and strike prices, with time and volatility considered. Even though it is based on assumptions, the Black-Scholes model is a good way to estimate possible premiums.

Binomial Model:

To figure out the premium, the Binomial model uses a discrete-time structure. It uses a binomial tree to describe many possible future events. This method looks at the various payouts for the option at each node until the option expires. Discounting the expected numbers gives us the total premium. You can use the Binomial model for European and American options, which gives you much freedom in figuring out premiums.

Also Read: Mutual Funds Vs Fixed Deposits: Which Is Right For You?

Conclusion

You get its premium when you add up an options contract’s intrinsic and extrinsic values. Models like Black-Scholes and the Binomial framework make it possible to estimate these numbers in a structured way. Understanding these calculation methods provides insights into how option premiums are determined.

Disclaimer: Investments in the securities market are subject to market risks; read all the related documents carefully before investing.

FAQs