AgenciesIn the last lesson, we discussed the option premium pricing for ITM ATM , and OTM just at a glance . Let’s understand the premium pricing in more 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.Now let’s understand what are these values.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 its premium.Since ATM is closest to CMP, ATM will have the highest Extrinsic value.Click here for the complete series & other learning content:Let’s understand this with an example:Consider SBIN share is currently trading at 540ATM call strike will be 540 CEATM CE value = Extrinsic valueLet’s assume current Extrinsic value is 5.So, 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 CE560CE570 CELet’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 valueIntrinsic value is simply the difference between the current market price and 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 deeper into ITM.For the same example of SBI at CMP 540.The ITM CE strikes will be:510 CE520 CE530 CEThe 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) = 31Net premium of 520 CE = 20 + 2 = 22Net premium of 530 CE = 10 + 3 = 13The 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 affects 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)

Source: Economic Times May 03, 2023 01:05 UTC