How are Options priced?
Introduction to Options
Options are derivative contracts which give the holder the right (but not the obligation) to buy (call option) or sell (put option) a security at a particular price before or at the expiration of the contract.
For example, a CNX Nifty put option (Benchmark Indian Stock Market Index) may look like
October 2013 PE 5800 having a lot size of 50, quotes at 146 on October 1st 2013.
This means that the contract expires by the last Thursday of October 2013 (31st). PE stands for Put European. European options can be exercised on expiry day only while American options can be exercised on any day.
Put options give the right to sell the underlying security (Nifty in this case) at 5800 which is called the strike price. It is the price at which you can sell the security.
So in our example, if Nifty is at 5400 on October 31st 2013, then the option holder can exercise the option which gives him the right to sell Nifty at 5800. But since its trading at 5400 on October 31st, he immediately pockets the difference of 400 points. (5800 which is the strike price – 5400 which is the current price on 31st Oct).
His profit would be equal to 254 (400 – 154) because he paid 146 to purchase this contract on October 1st.
Since the lot size is 50, both the profit and loss along with the cost need to be multiplied by 50 to arrive at the actual figures in Rupee terms. In this case our cost of buying the option would be Rs 7,300 (146*50) and our subsequent profit would be Rs 12,700 (254*50)
European options can be exercised only on expiry (31st October in this case) but can be sold anytime.
Options pricing explained
Options have two broad components in their price. More »