What is value of options? Why is it important?
Options are the derivatives of the Stocks or Index such as NIFTY or NIFTY BANK which are traded by the Stock Exchanges NSE and BSE. So, the value of the options is derived from the value of the underlying asset. The value of an option is the current market price of that option at which is being traded in the stock market. Its value depends on various factors, but more importantly there are two major factors which govern the value of an option, they are –
- Intrinsic Value
- Time Value
To understand the two terms in detail, we need to take an example in real scenario. Let us take the NIFTY 50 Index which is trading at 14,677.80 as on May 14, 2021. It is the benchmark index of NSE having the market value of the top 50 companies having highest market capitalization. Market cap means the total number of shares of the company multiplied by the share price.
|Strike Prices||14000 CE||14600 CE||15000 CE|
|Total Premium (May 27 2021 expiry)||752||277||81.50|
The data in the green color can be found from the NSE Option Chain website (https://www.nseindia.com/option-chain) or from any brokers’ trading platform.
Intrinsic Value is the difference between the Current Value of the Underlying Stock/Index (NIFTY 50 index here) and the strike price of that option. It can never be in negative, either it is positive or zero.
Time Value is the difference between the total premium value and the intrinsic value of the option.
From the table, we can summarize,
- The intrinsic value of the option decreases as we move above the current price of the underlying asset and increases as we move below the current price.
- The time value is maximum at the current market price and it decreases on the either side.
The Time value signifies that how much time is left from the date of expiry in terms of value. As the time will pass, the time value will go on decreasing and at the end of expiry, the time value will decay down to 0 and only the intrinsic value will remain as the total premium value.
Classification of Options based on Intrinsic Value –
- ITM Option:- ITM option stands for In the Money Option. It means the strike price of the option is less than the Current Price of the underlying stock/index for a Call Option and it is more than the current price for a Put Option or in other words, the intrinsic value is not equal to zero. For Ex – If Nifty is trading at 14600, So all the call options with Strike Prices lower than 14600 are ITM options and all the Put Options of strikes higher than 14600 are ITM options.
- ATM Option:- ATM option stands for At the Money Option. It means the strike price of the option is equal to very close to the current price of the underlying stock/index for both the PE and CE options. In above example, 14600 CE and PE option will be ATM options.
- OTM Option:- OTM option stands for Out of the Money Option. It means the strike price of the option is more then the current price for a Call option and lower than the current price for a Put Option. Again, for above example, all call options with strike prices more than 14600 are OTM and all put options with strike prices lesser than 14600 are OTM.
Nothing in the world comes for free. It has some premium!!