Thread by @tradersushma

📖OPTIONS KI PAATHSHAALA📖

Thread on ~

📍 Option Price & its Components 📍

#threadbytradersushma
#OptionsTrading
#StockMarketindia

The price of an options contract is known as the option PREMIUM, which is the amount of money that the buyer of an option pays to the seller for the right, but not the obligation, to exercise the option.

(src:investopedia)

Option Price or Premium comprises of two components:

1. Intrinsic Value &

2. Extrinsic Value or Time Value or Time Premium

INTRINSIC VALUE

An option has intrinsic value if it enables the holder of the option to buy low & sell high or sell high & buy low. Intrinsic value is the difference between buying price & selling price.

E.g., If a stock is trading at Rs 435, Intrinsic value of a Rs 400 CALL is Rs 35. It’s because, by exercising this 400 CALL, the option holder can buy stock @ Rs 400 call & then sell it at market price of Rs 435 & thus get the credit of Rs 35 in his a/c.

🔹It is a measure of an option's profitability based on the strike price versus the stock's price in the market.
🔹Basically, the intrinsic value is the amount by which the strike price of an option is profitable.

🔹For option buyers, the Intrinsic Value represents a credit or positive value.
🔹For option sellers, the Intrinsic Value represents a debit or negative value.

🔹A call will have Intrinsic Value if its strike price is below mkt price.
🔹A put will have Intrinsic Value if its strike price is above mkt price.

Call Intrinsic Value = Spot price – Strike price

Put Intrinsic Value = Strike price – Spot price

🔹No option can have Intrinsic Value less than 0.
🔹Intrinsic Value is independent of expiry date coz it is the portion of an option's price not lost or impacted due to the passage of time.

EXTRINSIC VALUE/TIME VALUE/TIME PREMIUM

It is the additional amount of premium beyond the Intrinsic Value that an option buyer is willing to pay to option seller to compensate for the time risk which the option seller is taking.

As a result, time value is often referred to as an option's extrinsic value since time value is the amount by which the price of an option exceeds the intrinsic value.

🔹Usually, an option’s price is greater than its Intrinsic Value & the amt by which it is greater is the time value.
🔹An option’s price is always composed of precisely its Intrinsic Value & its Time Value although one or both of them can be 0 sometimes.

🔹If the option has no Intrinsic Value, its price will only consist of Time Value.
🔹If the option has no Time Value, its price will only consist of Intrinsic Value.

ITM, ATM & OTM OPTIONS

They refer to an option's moneyness that describes the intrinsic value of an option's premium in the market. This classification helps the trader to decide which strike to trade, given a particular circumstance in the market.

1) ITM – An option that has a positive intrinsic value is said to be ‘in the money’ by the amt of the intrinsic value.

2) OTM – An option with no intrinsic value is said to be “out of the money” & its price consists only of time value.

3) ATM – An option whose strike price is equal to the current market price of the underlying contract is said to be “at the money”. Technically it is also an OTM as it has no intrinsic value. These are most actively traded.

Call options are ITM if strike price is lower than the market price.

Put options are ITM if strike price is higher than the market price.

🔹If a call is ITM, then put with the same strike of the same underlying must be OTM & vice versa.

🔹At expiry an ITM will always have some intrinsic value while an OTM will have no intrinsic value.

🔹Both call and put options can be simultaneously ATM.

That's all for this thread. I shall cover more on options basics in forthcoming posts. Stay tuned.

If u found it useful, RT 1st post of the thread to share the knowledge.

Meanwhile follow @tradersushma for more such knowledge stuffs on trading & investing.

Most of my content is borrowed from this exhaustive book on Options ~

"OPTIONS VOLATILITY & PRICING"
by Sheldon Natenberg

If u want to be an options trader, this book is the best textbook of all.