Equity Options Valuation

What are the factors that determine the option value?

• Time to maturity - The more time you have until expiry, the more chance of the option ever getting in the money and being exercised and actually worth something
• Spot price relative to strike price - For CALLS, which are options to BUY a stock, if the spot increases, then this option becomes more valuable because the stock is now worth more, and you can buy it for a fixed price, for PUTS, a move lower in spot price will make the option to SELL more valuable
• Implied volatility - This signifies how much the market expects the stock to move on an annualised basis
• Interest rates, dividends and borrow cost - options expire at some point in the future, they are priced from the forward price

What are the different Greek Letters to signify an options sensitivity?

1. Greek associated with time = Theta (Θ)
2. Greek associated with sensitivity to spot = Delta (δ)
3. Greek associated with implied volatility = Vega (v)

What is a Forward Price?

Forward price - This is the fair market assumption as to where the underlying asset should be at expiration, provided that all things are equal.

FORWARD PRICE = S (1+R-B)^T - DIVS

Where,

• S = Spot price
• R = risk free rate
• B=borrow rate
• T= maturity in years
• DIVS= total dividends expected to be paid before expiry

What are the components of the forward price?

• Spot price
• Interest rates
• Dividends
• Borrow cost

What are the two components of option value?

• Intrinsic value - Intrinsic value is the amount an option is in the money by, out of the money options have no intrinsic value. It can never be negative
• Time Value - The remainder of the option's value beyond its intrinsic value. Time value exists because an option has time to become in the money, even if it currently has no intrinsic value