The basics of option premium determination

Updated: Apr 30 2007, 08:16am hrs
How are option premiums (prices) determined

While supply and demand ultimately determines the price of options, several factors have a significant impact on option premiums, which are

Spot Price of the underlying assets

The exercise price of the option

The volatility in the underlying markets.

Time remaining to expiration

Risk free rate of interest

Dividend (only for option on equity)

Define breakeven points

Breakeven point is the point at which there is no net loss or gain, one has just broken even. The maximum amount the option buyer can lose is the premium that he originally paid. It is that point where the payoff of the buyer is exactly equal to the amount of premium paid. To calculate the breakeven point on options, one uses the strike price and the premium.

Breakeven point Calculation

Call Option = Strike Price + Premium amount.

Put Option = Strike Price - Premium amount.

What is put/call ratio and how is it used

The put-call ratio is simply the number of puts traded divided by the number of calls traded. It can be computed daily, weekly, or over any time period. It can be computed for stock options, index options, or options on futures. Some market technicians believe that a high volume of puts relative to calls indicates investors are bearish, whereas a high ratio of calls to puts shows bullishness.

What does the term delta mean

Delta measures the rate of change of an option premium with respect to a price change in the underlying asset. Delta is a measure of price sensitivity at any given moment. Not all options move point for point with their underlying asset.

If an underlying asset moves 0.50 points and the option only moves 0.25 points, its delta is 50%; that is, the option is only 50% as sensitive to the movement of the underlying asset.

The delta is between 0 and +1 for calls and between 0 and -1 for puts (thus a call option with a delta of 0.5 will increase in price by 1 tick for every 2 tick increase in the underlying).

How does deep-in-the-money differ from just In-the-money

When someone refers to a deep-in-the-money option they are referring to a call or a put with a delta close to 1.00 (or -1.00 for puts). This option moves very close to a one for one ratio with underlying asset movement up and down, and is often viewed as the equivalent for long or short underlying asset.

Courtesy MCX Training