Recently, one of our fincareplan readers asked a question related to option premium. It was a little complicated but we try to answer his question. The question was, he took the Nifty 13400 call option at the premium of 200 Rs on 9th December 2020, and the next day would be weekly expiry. He was taken weekly expiry calls.
At the time of bought Nifty was trading around 13400 and it’s slowly moved to 13420 but the call option premium was decreased by 10% (180). He was wondering, how the option premium reduced when the spot price is increasing.
The main reason was the Implied Volatility of the option strike price. Most of the traders have no idea about these terminologies. Before understanding Implied volatility, let us understand the basics of option pricing.
Option premiums are calculated from two important factors
- Intrinsic value
- Time vale
For example, ITC was traded around 215 and you want to trade 210 strike call option this means, your option is In-The-Money call. The difference between the underlying price and stock price is 5 that’s is the intrinsic value of the option.
Intrinsic Value = underlying price – strike price
By using the above example, the 210 call option was traded around 8 Rs premium. It indicates the option premium is priced at 3 Rs more than its intrinsic value. Here time value comes into the picture.
Time value is the additional premium that is priced into an option, which represents the time left until the expiry of the contract. The time value of the option is influenced by different factors
- Stock price
- Strike price
- Interest rate
- Time decay
- Implied Volatility
Let us try to solve the question by using implied volatility. It represents the expected volatility of a stock over the life of the option. Remember the word expectation, whenever marker expectation decreases, the demand for an option diminishes. Implied volatility doesn’t forecast the direction of the stock price. If the IV is high, the market participant thinks, the stock has the potential for bigger movement in either direction.
HISTORICAL VS IMPLIED VOLATILITY
Options traders usually focus on historical and implied volatilities, the first one is the annualized standard deviation of past stock price movements. It measures the daily price change over the year.
Implied volatility is derived from option price and it shows what the market implies or expects about the volatility in near month contract. It acts as a substitute for the option premium, the higher the IV, the higher the option premium. Most trading volume occurs in at-the-money option, these are the contracts generally used for the IV calculation. We don’t enter into the complex option pricing models.
With an option IV, we can calculate the expected range of the stock by expiration. By using the standard deviation, we will define the expected range of the stock price.
For example, ITC traded around 215 with an annualized volatility of 40% and an At-the-money call option of December expiry trade around 33%. What it implies, how to interpret these data?
Let’s calculate the standard deviation move of the stock
Standard deviation range = stock price * IV * √ calendar days / 365
= 215* 40%* √30/365
= + or – 1.5
As a result the stock is expected to finish between 213.5 and 217.5 after 30 days. Remember implied volatility of 40% will be annualized, so we must calculate our desire time period. Annual range of the stock will be 120 to 280.
Importance of Implied Volatility:
- Options are insurance contracts, if any uncertain events occurs there is more demand for insurance on that asset. The same way comes to the stock option if the option premium will become more expensive as market participants think that the stock will become more uncertain about the future.
- Whenever, company earnings announced, the stock price will fluctuate and the option prices are traded to higher, IV will increase.
- If all the news captured in the market, the stock price will come to normal, the IV of the option also drastically reduced.
- Buy the option at low IV and sell the option at high IV. It will applicable in both call and put option buying.
Option buyers get a maximum benefit when IV will increase not spot price movement. Let’s come to the question once again, he bought a call option at 20% IV end of the day IV close at 15%.
That’s the reason option premium got reduced. Whenever Implied Volatility spikes sellers ready to sell the option to get a decent profit. We need to analyze the volatility range and set up the trades based on that calculation.