Option Valuation

INTRINSIC VALUE OF OPTION

The intrinsic value of an option is the money the option buyer makes from an options
contract provided he has the right to exercise that option on the given day.
Intrinsic Value is always a positive value and can never go below 0.
Underlying CNX Nifty
Spot Value 8070
Option strike 8050
Option Type Call Option (CE)
Days to expiry 15
Position Long

How much money would you stand to make provided you exercised the contract today?
 CONT…

• Intrinsic Value of a Call option = Spot Price – Strike Price

• Let us plug in the values
• = 8070 – 8050
• = 20
• So, if you were to exercise this option today, you are entitled to make 20
points (ignoring the premium paid).
Option Type Strike Spot Formula Intrinsic Value Remarks

Spot Price –
Long Call 280 310 310 – 280 = 30
Strike Price

Strike Price –
Long Put 1040 980 1040 -980 = 60
Spot Price

Spot Price – Since IV

Long Call 920 918 918 – 920 = 0
Strike Price cannot be -ve

Strike Price – Since IV

Long Put 80 88 80 – 88 = 0
Spot Price cannot be -ve
 IMPORTANT POINTS –

1.The intrinsic value of an option is the amount of money you would make if
you were to exercise the option contract
2.The intrinsic value of an options contract can never be negative. It can be
either zero or a positive number
3.Call option Intrinsic value = Spot Price – Strike Price
4.Put option Intrinsic value = Strike Price – Spot price
 MONEYNESS OF A CALL OPTION

Moneyness of an option is a classification method that classifies each option

strike based on how much money a trader will make if he were to exercise his
option contract today. There are three broad classifications –
1.In the Money (ITM)
2.At the Money (ATM)
3.Out of the Money (OTM)
 IN THE MONEY" (ITM)

• The phrase in the money (ITM) refers to an option that possesses intrinsic
value.
• An option that's in the money is an option that presents a profit
opportunity due to the relationship between the strike price and the
prevailing market price of the underlying asset.
 OUT OF THE MONEY (OTM)

• An OTM call option will have a strike price that is higher than the market
price of the underlying asset.
• Alternatively, an OTM put option has a strike price that is lower than the
market price of the underlying asset.
 AT THE MONEY (ATM)

• At the money (ATM) is a situation where an option's strike price is identical

to the current market price of the underlying security.
• Both call and put options can be simultaneously ATM.
Option Value Payoffs

Call buyer profit – assume strike of $530 and option price of $36.00

Long call
Position value
Break even

-36.00

530 566.00

Share price
 Option Value Payoffs

Put seller profit – assume strike of $530 and option price of $34.55

Position value
Break even
Short put
+34.55

495.45 530

Share price
 13

Options Chapter 29
 14

Options Chapter 29
 Put option Pay off

https://financetrain.com/put-option-payoff
 Graphical View
Call Holder & Writer

Graphical View; Pay off of Call Option for Buyer and Seller

Pay off Pay off

HOLDER/BUYER WRITER/SELLER

(S-X-c)

X c
-c Price, S X Price, S

- (S-X-c)

Options
 Graphical View
Put Holder & Writer

Graphical View; Pay off of Put Option for Buyer and Seller
Pay off Pay off
HOLDER/BUYER WRITER/SELLER

-(X-S-p)
X p
X

Price, S Price, S
(X-S-p) -p

Options
 18

Options Chapter 29
 THE “GREEKS”

 Delta
 Gamma
 Vega
 Theta
 Rho
20
DELTA
Delta: Delta measures the rate of change of the option price with respect to
changes in the underlying asset's price. It essentially tells you how much the
option price will change for a $1 change in the underlying asset's price.

Gamma: Gamma measures the rate of change of the option delta with respect
to changes in the underlying asset's price. It represents the rate of change in
delta for a $1 change in the underlying asset's price.

OPTIONS CHAPTER 29
21
DELTA

Vega: Vega measures the sensitivity of the option price to changes in volatility. It
tells you how much the option price will change for a 1% change in implied
volatility.

Theta: Theta measures the rate of change of the option price with respect to the
passage of time. It indicates how much the option's price will decrease as time
passes, all else being equal.

Rho: Rho measures the sensitivity of the option price to changes in interest rates.
It tells you how much the option price will change for a 1% change in interest
rates.

OPTIONS CHAPTER 29
OPTION GREEKS (SUMUP)
OPTION VALUATION

• Option valuation is the process of determining the fair price

or value of an option. An option is a contract that gives the
holder the right, but not the obligation, to buy or sell an
underlying asset at a predetermined price and time in the
future. The value of an option is determined by various
factors, including:
 DETERMINANTS OF OPTION VALUE

1.The price of the underlying asset: The price of the underlying asset is the most important
factor in determining the value of an option. A call option will increase in value as the price
of the underlying asset increases, while a put option will increase in value as the price of the
underlying asset decreases.
2.The strike price: The strike price is the price at which the option can be exercised. For a call
option, the strike price should be lower than the current price of the underlying asset to have
any intrinsic value, while for a put option, the strike price should be higher than the current
price of the underlying asset.
3. Time to expiration: The longer the time to expiration, the higher the value of an
option, as there is more time for the underlying asset to move in the desired
direction.
4. Volatility: Volatility refers to the degree of price fluctuations in the underlying
asset. Higher volatility increases the value of both call and put options, as there is a
higher chance of the underlying asset moving in the desired direction.
5. Interest rates: Interest rates affect the cost of holding the underlying asset and can
impact the value of an option So an increase in interest rates will increase the call
option values, while increase the interest rate leads to decrease the value of puts.
• Purchasing 100 shares of a stock trading at $100 will require $10,000,
• assuming a trader borrows money for trading will lead to interest payments on this capital.
• Purchasing the call option at $12 in a lot of 100 contracts will cost only $1,200.
• Yet the profit potential will remain the same as that with a long stock position.
• Effectively, the differential of $8,800 will result in savings of outgoing interest payment on
this loaned amount. Alternatively, the saved capital of $8,800 can be kept in an interest-
bearing account and will result in interest income—a 5% interest will generate $440 in one
year
• Thus, an increase in interest rates will lead to either saving in outgoing interest on the loaned
amount or an increase in the receipt of interest income on the savings account. Both will be
positive for this call position + savings. Effectively, a call option’s price increases to reflect this
benefit from increased interest rates.
• Shorting a stock with an aim to benefit from a price decline will bring in cash to the short
seller.
• Buying a put has a similar benefit from price declines, but comes at a cost as the put option
premium is to be paid.
• This case has two different scenarios: cash received by shorting a stock can earn interest for
the trader, while cash spent in buying puts is interest payable (assuming the trader is
borrowing money to buy puts).
• With an increase in interest rates, shorting stock becomes more profitable than buying puts,
as the former generates income and the latter does the opposite. Thus, put option prices are
impacted negatively by increasing interest rates.
A SUMMARY OF THE DETERMINANTS OF
OPTION VALUE
Factor Call Value Put Value
Increase in Stock Price Increases Decreases
Increase in Strike Price Decreases Increases
Increase in variance of underlying asset Increases Increases
Increase in time to expiration Increases Increases
Increase in interest rates Increases Decreases
Increase in dividends paid Decreases Increases
 METHODS OF OPTION VALUATION

• Black Scholes Merton model (Black-Scholes model): This model takes into
account several factors, including the current price of the underlying asset,
the strike price, the time to expiration, the risk-free interest rate, and the
volatility of the underlying asset
 HISTORY
• The Black-Scholes model is a widely used mathematical model for option pricing. It was
developed by Fischer Black and Myron Scholes in 1973, and later extended by Robert
Merton. The model is based on the assumption that the price of the underlying asset
follows a random walk, and it takes into account several factors, including the current price
of the underlying asset, the strike price, the time to expiration, the risk-free interest rate,
and the volatility of the underlying asset.
• The Black-Scholes model provides a theoretical value for an option, which is known as the
"fair value" or "theoretical price" of the option. The model assumes that the option can
only be exercised at expiration, and that there are no transaction costs or dividends paid on
the underlying asset during the life of the option.
 ASSUMPTIONS OF THE BLACK-SCHOLES MODEL

1.The underlying asset follows a random walk: The Black-Scholes model assumes that
the price of the underlying asset follows a random walk, meaning that it is impossible
to predict its future movement with certainty.
2.The option can only be exercised at expiration: The Black-Scholes model assumes
that the option can only be exercised at its expiration date, and not before.
3.There are no transaction costs: The Black-Scholes model assumes that there are no
transaction costs involved in buying or selling the underlying asset or the option
contract.
4. The risk-free interest rate is constant: The Black-Scholes model assumes that the risk-free
interest rate remains constant throughout the life of the option.
5. Returns are log Normally distributed : The Black-Scholes model assumes that the returns
of the underlying asset are normally distributed. The assumes that the volatility of the
underlying asset is constant throughout the life of the option.
6. There are no dividends paid during the life of the option: The Black-Scholes model
assumes that there are no dividends paid on the underlying asset during the life of the
option.
 THE FORMULA FOR THE BLACK-SCHOLES
MODEL
• C = SN(d1) - Kexp(-rT)*N(d2)
Where C is the call option price
• S is the current price of the underlying asset
• K is the strike price of the option
• r is the risk-free interest rate
• T is the time to expiration of the option
• N() is the cumulative distribution function of the standard normal distribution
• d1 = (ln(S/K) + (r + 0.5sigma^2)T) / (sigmasqrt(T))
• d2 = d1 - sigmasqrt(T)
 ND1 =0.5807 , ND2 = 0.5445

• Nd 1

Nd 2
ND1 =0.6684 , ND2 = 0.6425
SUPPOSE THAT COMPANY XYZ STOCK IS CURRENTLY TRADING AT $50 PER
SHARE. YOU ARE INTERESTED IN PURCHASING A CALL OPTION ON THE
STOCK, WITH A STRIKE PRICE OF $55 AND AN EXPIRATION DATE OF 3
MONTHS FROM NOW. THE RISK-FREE INTEREST RATE IS 2% PER ANNUM,
AND THE VOLATILITY OF THE STOCK IS ESTIMATED TO BE 20% PER ANNUM.
• Using the Black-Scholes model, we can calculate the theoretical value of the call option as follows:
• d1 = [ln(S/K) + (r + σ^2/2)t]/(σ√t) d2 = d1 - σ√t
• where: S = current stock price = $50 K = strike price = $55 t = time to expiration (in years) = 3/12 =
0.25 r = risk-free interest rate = 2% per annum = 0.02 σ = volatility of the stock = 20% per annum =
0.20
• Substituting these values into the formula, we get:
• d1 = [ln(50/55) + (0.02 + 0.20^2/2) x 0.25]/(0.20 x √0.25) = -0.286
• d2 = -0.286 - 0.20 x √0.25 = -0.486
• Using the cumulative normal distribution function, we can find that N(d1) = 0.386 and
N(d2) = 0.315. Therefore:
• Value of call option = S x N(d1) - K x e^(-rt) x N(d2) = $50 x 0.386 - $55 x e^(-0.02 x
0.25) x 0.315 = $2.22
TO VALUE A PUT OPTION USING THE BLACK-SCHOLES
MODEL, THE FOLLOWING STEPS CAN BE FOLLOWED:
1.Determine the current stock price (S), the option's strike price (K), the time to expiration
(T), the volatility of the underlying stock (σ), and the risk-free interest rate (r).
2.Calculate the option's d1 and d2 values using the following formulas:
3.d1 = [ln(S/K) + (r + σ^2/2)T] / (σ√T)
4.d2 = d1 - σ√T
5.Put Option Price = K e^(-rT) N(-d2) - S N(-d1)
SUPPOSE YOU ARE CONSIDERING BUYING A PUT OPTION ON STOCK
XYZ. THE CURRENT STOCK PRICE IS $100, THE OPTION'S STRIKE PRICE
IS $90, THE TIME TO EXPIRATION IS 6 MONTHS, THE VOLATILITY OF THE
UNDERLYING STOCK IS 25%, AND THE RISK-FREE INTEREST RATE IS 3%.

To value the put option using the Black-Scholes model, we can follow these steps:
1.Determine the values of S, K, T, σ, and r:
2.S = 100
3. K = 90
4. T = 0.5 (6 months in years)
5. σ = 0.25 (25% expressed as a decimal)
6. r = 0.03 (3% expressed as a decimal)
 CALCULATE D1 AND D2:

1. d1 = [ln(S/K) + (r + σ^2/2)T] / (σ√T)

d1 = [ln(100/90) + (0.03 + 0.25^2/2) x 0.5] / (0.25 x √0.5) = 1.1093
2. d2 = d1 - σ√T
d2 = 1.1093 - 0.25 x √0.5 = 0.8266
Put Option Price = K e^(-rT) N(-d2) - S N(-d1)
Put value= 90 x e^(-0.03 x 0.5) x N(-0.8266) - 100 x N(-1.1093) = $12.67
 NORMAL DISTRIBUTION VALUE CALCULATOR

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