What is Option Pricing? Definition, Features, Goals, And More

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March 25, 2023 Jayant Sharma Financial Modeling, Knowledge

With growing financial literacy among the masses, there is growing awareness about the value of stocks and shares of different companies in the market. These assets are utilized for financial security in the future by common people who invest because it is a financially sound plan of action. However, investment in financially well-positioned companies brings stability of returns in the long term but does not change your financial situation in the short term. For those looking to add a short-term instrument for capitalizing on quick market movements, options are the key. To understand them you need to know option pricing…

Before understanding the concept of option pricing, wrapping your head around the derivative market is a bit of a head-scratcher. As someone who knows the ambiguous feeling of tackling financial jargon, I shall not deliver information about options in high-flown language but rather simply explain all the terms I use. In the article that follows, we’ll first explore the intricacies of the derivative market, understand the derivatives from a stock-driven perspective, and then move to understand the technicalities and key features of options. This will lay the groundwork for financial option pricing, after which we shall dive into the many factors that regulate the prices of options in the market.

Without proper comprehension of the basic precursors to option pricing, however, little can be relayed without losing content to the murky feeling of disconnectivity. Let us begin without any delay with the topic of…

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Derivatives In Finance:

Derivatives are financial instruments that do not hold value but are mirroring the value of underlying securities such as stocks. Furthermore, they are founded on underlying assets as well. Their prices fluctuate over time depending on multiple variables of different kinds. They possess selective markets where they can be traded privately as well as publicly. Significant features of derivatives are their independence from direct ownership to shares and the ability to hedge prices and seek profitability by predicting directional changes of the price moving and picking the ones that favor their finances. They are also effective as leverage tools as varying positions in their price are utilized as means to offset other obligations.

They are complex phenomena at work in this field and thus, derivatives are not recommended for finance beginners who have little idea about the factors and interactions among them that determine factor pricing. For instance, when an investor overseas buys derivatives in the Indian market, they need to not only ensure that the factors that work on derivative pricing remain as per their predictions but also check the extent of the derivative value that will be affected due to adverse change in the exchange rate of the different currencies. This phenomenon is known as exchange rate risk and such phenomena are common in this market.

Now that you have some insight into the complexity and the value of derivatives, they can be of multiple types but seen from a stock transaction purpose, they can be categorized into four types:

The major class of derivatives is the locks that bind parties in the agreement of the term of the contract throughout its shelf life. While on the other hand, options are derivatives that only provide the right for the buyer or seller to exchange the security for 100 shares at a specific price before or on the expiration date. There is no obligation in the second class of derivatives, and it allows for some flexibility. Futures, Forwards & Swaps form the ‘lock’ class while Options are in their category. The unique nature of options is another reason why learning about option pricing is essential.
Futures are financial contracts that exchange assets on agreed-upon prices at a future date. These are assurances to both buyers and sellers and are seen as risk-reduction contracts that are based on future financial predictions. The obligations to buy and sell the asset are absolute. These contracts can also aid in speculating future downturns and prevent losses or gain profitable products in case of the prediction of future price rises.
Forwards are similar in many ways to futures however they trade over the counter i.e. forwards are exchanged in relatively open markets whereas OTC is a key feature of exchange between private entities. These contracts are extremely vulnerable to counterparty risks which are a type of credit risk wherein one of the two parties involved in the exchange does not fulfill its obligations and defaults, leaving the other party little to no recourse to gain the desired value through contract. Furthermore, these can be leveraged out to other counterparties thus, stockpiling the risk of this financial contract.
Swaps are a vital derivative that have a great potential for misuse as is evident in the 2008 credit crisis where counterparty risk of swaps lead to defaulting banks and forced write-offs. Majorly these derivatives are related to cash flows and the management of the exchange of certain rates.
Lastly, options are a derivative that is considered similar to a future but where there is no obligation of exchange or transaction, only the right to do so under favorable conditions. They are based on the prices of the subsequent stock price of the company. Let us understand more about them and in turn, about option pricing …

Options: Features & Uses

As per the Chicago board options exchange, 1.1 billion options contracts were sold through the system in 2016. It is normal to wonder why you need to focus on this derivative investment and not on the real deal security of shares which forms the basis of its value in the first place. This is because options don’t simply follow the increases and decreases in the values of stocks but are based on multiple factors of investment that can revolutionize the reach of your portfolio. Derivatives are investments that are based on certain securities and ratios from which the core of their value is derived. Consider them akin to a betting game where people exchange a simple sum to gain a bigger one if their predictions are right. The basic procedure of stock options selling and buying is dependent on the exchange between an option writer and an option holder.

(seller/buyer) on a set price of the stock to be delivered. It is an agreement that if the option is financially valid there is room for future buying or selling of the stock at the agreed price. The right to buy a share is called a call and the option to sell that share is called a put. Profitability of the strike price is key which is dependent on stock price rise and fall. There are marked differences in an options value exchange period, expiry, and much more in the case of different locations. For instance, in America, the option can be utilized till the expiration date whereas in Europe the option can only be exchanged for 100 shares on the expiration date.

Some people might be wondering why not put the same effort into the underlying asset and gain profitable outcomes. This is not true as the returns to the derivative are much more exponential compared to changes in a stock’s price. For instance, a 10 USD share can change to 12 USD and you would gain 200 USD if you had bought 100 shares as compared to 100 USD on an option after a 1 USD premium per share. However, in case the price goes down a put option can fetch you a profit still while you won’t get a benefit if you simply owned the asset i.e. share. Price change gets you the return but only as per the market change and rise. However, in-the-money and out-of-the-money concepts in option make it a far more reliable option for racking up short-term profit as you don’t need to use the option and replace it with a stock if you are at a loss and you only pay the premium in all cases.

Similarly, there are sell-or-put cases where the downside can only be the 1 USD per share you paid in premium since the principal amount that has been struck does not change. So, options act like insurance, but also give you the flexibility for capitalizing on any expected market movements. This is only the tip of the iceberg since other than hedging they lead to an increase in overall risk in your portfolio. Options unlike stocks are held in the long run only when there is a losing side in the bet. Writing options is a very risky business as most of the good things get inverted on their head. You might have to give out a call option as a writer which may increase manifold. Then you buy the option and have to cover the call at a significant loss while your premium amount is your profit cap.

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To prevent this most option writers, cover their call of the stock unit known as covered call… However, there is still a world of timings of stock prices and then the coverage of calls and put options that come into the picture in a meaningful way. The multitude of uses for stock options are as follows:

Options are excessively used for speculation purposes since predicting the direction of the stock price can net you a significant number of profits. They can come packaged in different types of options. These two types are:

Put Options: These are options that are bought by investors under circumstances where the stock price will fall and sold by them if the price will rise.

Call Options: These are the options that are sold by investors under circumstances where the stock price will rise and bought by them if the price will fall.

The options operate on the principle of in-the-money and out-of-the-money. The option pricing i.e., the strike price is the major component in tandem with future financial expectations for choosing between these types of stock options.

There is an unregulated third type of option called the binary option. These are options that do not rely on option pricing factors but have fixed returns or no returns. This is because they are based on a yes or no proposition that is determined by the rise or fall in the value of an asset to a specified amount. These are not to be given the spotlight as they are unregulated by the government and the market is rampant with fraud and malpractice. Regardless, they are advanced financial tools and are extremely speculative and risky.

Generating Income

Many options are written for the sole purpose of gaining income over time of the life of an option through the premium acquired. It is also a good way to gain income in the short term if you can handle the risk that it offers. However, income generation with this tool is an inconsistent affair that can be rectified through the appropriate knowledge of financial conditions in an economy.

Hedge Risks

Options are a way to make money when the market is stable or falling, combined with other securities for risk management. A future expected loss can be limited to the premium by opting into the put option of an already-bought call option. When hedging risk, it’s important to ensure that the premium is not too high, otherwise, the loss incurred can be massive.

Why do traders focus on stock options? Because they have leverage and dollar-to-dollar potential payout in options. Technically this would mean that options require more capital, but they can be offset by other securities or other option positions. The returns are greater and much more flexible. However, let us get an overview of the other side…

The Disadvantages of Options:

Options can come in various shapes and sizes. Their attributes are numerous, and their uses have been clearly outlined previously. However, option pricing is not established simply through advantages but also takes into account the disadvantages of a stock. Some of these cons are:

Options share many of the downsides of insurance. To avail of the benefits of the instrument, a premium is required before the sale or over the time decay period of the option. In case of failure of timely payment of options, there is no coverage and in case you find yourself in a situation where you are out-of-the-money (financial prediction goes sideways), the loss won’t be covered by the seller, thus costing you funds. The higher the risk in the market situation the more of a premium payment is required.

Furthermore, options have an expiry date, so you can only ensure a position for a certain time. To continue onwards you need to buy new options on the put or call kind and pay the premium asked all the time. Thus, they are only temporary securities.

Moreover, the more likely you are to exercise an option the more expensive it can be, i.e. the strike price being below the stock price would be a given buy but due to a higher premium, the money can always be compensated over time or immediately when you try to call an option some services have clauses in their options selling contracts of paying an extra premium if the next due date has not arrived. Therefore, they require investing competency and cannot be utilized. Even though they work like bonds in the sense that they can be sold prematurely if a more profitable position is present in the market there is a lot to learn about options and market rates before such a thing can be developed.

Offer returns of great value in the short term but they are only limited to the short term. They have expiration dates after which can result in being worthless. Only effective short-term and short-term fluctuations are suspected to change due to multiple factors thus turning the prediction of these financial tools into a fool’s game. Instruments that have high risk and can result in short-turn profits. Nothing more than a gamble if not used properly. Now we can finally come to the crux of the article which is …

Options Pricing & Factors:

In simple terms, option pricing is the fair value given to an option that assumes that it will be exercised under in-the-money conditions. Taking the probability of that circumstance and assigning a monetary value to it is a difficult task. Variables like volatility rate, interest rate, and others are applied to carry out the exact calculations for pricing. Such input variables are utilized to generate Greeks. These are considered general benchmarks for traders to tally the fluctuating rates in the market against and help in considering how elastic a trade is to fluctuations in price, volatility, etc. Every market has two sides, a demand, and a supply side, where one seeks to sell high and buy low whatever the situation may be. Option holders and sellers are both in this bet and are stuck to follow it through till a party comes out victorious. Keeping demand on one side of the shore and supply on the other, let us investigate some factors of option pricing:

1. Time to Expiration

Options act as insurance services and are based on monthly payments as well as have an expiration date. Furthermore, the longer the option time decay i.e. the decaying of an option over time the greater the value of the option as the holder would have much more to exercise the options, thus increasing the probability of an ITM situation for an option.

Options time value decay is also known as time decay. It’s not linear but exponential. Thus, the greatest value of trading options is found in quarterly and the least in weekly.

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2. Underlying Stock Price

Options are supposedly found at different price increments. The strike price is the predetermined price at which an option is exchanged if it is exercised.

For call options strike price and above is out of the money and vice versa for in the money. For put options strike price and below is out of the money and vice versa for in the money. As stock prices go up, calls become expensive and put become less so, and vice versa in the case of a stock price fall.

3. Volatility

It refers to the magnitude of a stock’s price. Volatility adds a new risk factor; the more risk, the more the cost of an option. For instance, comparing options to insurance again, the greater risk of dying in insurance leads to more money taken in premiums. Volatility is a much more predictable factor under option pricing which can act as the backbone of some trading strategies.

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4. Interest Rate

It is another factor that determines option pricing as a falling rate of interest can affect call options by raising the stock price despite it being financed through debt i.e., debt-fueled growth. These have a direct impact that improves call option returns while hampering the option pricing for puts.

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FAQs: (Option Pricing)

Q1. How are options taxed by governments around the world?

Most governments base their taxation on the time duration of holding an option. Their nature also affects taxation i.e. whether the options are naked or covered by security. They incur capital gains tax.

Q2. What is the assignment in options?

An assignment is the exact opposite of a choice exercise. When an option is assigned, the buyer or seller demonstrates the exercise of their respective rights. When an option is exercised, a seller or a buyer is chosen at random by the stock exchange’s trading software to fulfill the contract.

Consider that you sold a 400-call option on Tata Motors for a price of Rs 20. Tata Motors shares increased in value to Rs 440. It is feasible that a trader who purchased a Tata Motors 400 call might decide to exercise his option in such a situation. Now if there is a call, the loss incurred to honor the contract would be 40-20=20. No of whether the deal was profitable or unsuccessful, all option holders have the right to exercise their options.

Q3. What are the major differences between trading stocks versus options?

Well, the major differences between them are as follows:

Infinite time vs expiry date
Delivery in demat account vs no delivery
Actual high amount vs low premium 100 shares at the strike price

Conclusion:

We hope you gained valuable insight into options through this article on option pricing and its features.