Learn With ETMarkets: Do you know these components of option premium?

In the last lesson we discussed the option premium pricing for ITM, ATM and OTM just at glance. Let’s understand the premium pricing in detail in today’s section.

As discussed, ITM value is based on intrinsic value and extrinsic value and ATM/OTM will just have extrinsic value.

Click here for the complete series:

https://economictimes.indiatimes.com/newslist/54363265.cms

Now let’s understand what these values are.

Extrinsic value is based on the Black Scholes model, and to simplify the Extrinsic value, we can say, the higher the difference between CMP and strike price, lower is the extrinsic value, and hence you will notice the deeper the OTM, lower is its premium.

Since ATM is closest to CMP, ATM will have the highest Extrinisic value.

Let’s understand this with an example:

Consider SBIN share is currently trading at Rs 540

ATM call strike will be 540 CE

ATM CE value = Extrinisic value

Let’s assume currently Extrinsic value is 5,

(Note: The price used in the example is for reference and not buy or sell recommendations)

The premium of 540 CE will be 5, and no other strike will have an Extrinsic value greater than 5.

OTM call strikes will be:
550 CE

560CE

570 CE

Let’s try to calculate the premium pricing of these strikes -

As we go far from CMP, the Extrinsic value should drop down, so the value of 550 CE will be 3rs on similar lines 560 CE will have a premium of 2rs and 570 CE will have a premium of 1rs.

Let’s now calculate the premium pricing of in the money strikes:

ITM has Extrinsic value + Intrinsic value

Intrinsic value is simply the difference between the current market price and the strike price, and hence you will notice the deeper the ITM strike, the higher is its premium as the difference between CMP and Strike price keeps increasing as we go deep ITM.

For same example of SBIN at CMP 540,

The ITM CE strikes will be
510 CE

520 CE

530 CE

The Intrinsic value of 510 CE will be 30 (540 – 510), on similar lines Intrinsic value of 520 CE will be 20 (540-520) and for 530 CE it will be 10 (540-530)

And just like for OTM, the Extrinsic value of 510 CE will be 1, for 520 CE it will be 2 and for 530 CE it will be 3.

So Net premium of 510 CE = 30 + 1 (Intrinsic value + Extrinsic value ) = 31

Net premium of 520 CE = 20 + 2 = 22

Net premium of 530 CE = 10 + 3 = 13

The same logic applies to Put also.

Here is one live market option chain from a broker terminal with decoded values :


This clearly shows how Intrinsic value and Extrinsic value effects premium pricing.

In the next lesson, we will learn other factors affecting premium prices.

(The author is Co-founder Algofox.com)

(Disclaimer: Recommendations, suggestions, views, and opinions given by experts are their own. These do not represent the views of the Economic Times)