(upbeat percussive music)
-: The premium paid for an option
is also known as the option price,
and it reflects the value of that option.
An option's price reflects two key elements:
intrinsic value and time value.
Intrinsic value is the difference
between the option's strike price
and the forward price of the underlying asset.
For a call option, there is only intrinsic value
when the forward price is higher
than the option strike price.
For a put option, there is only intrinsic value
when the forward price is lower
than the option strike price.
If an option has intrinsic value,
we traditionally call the option in the money.
This means that there is real value in the option,
and it would be likely to be exercised.
Time value represents the probability
that the underlying asset's price
will move favourably prior to the expiry of the option.
We can calculate time value
simply as intrinsic value less the option price.
The pricing of options is complex,
and a variety of option pricing models exist
such as the Black-Scholes Model.
In practise, there are five key influences
on option prices.
Spot rates have a positive correlation with call options,
and a negative correlation with put options.
As the spot rate increases,
the value of a call option increases.
This is because there is a higher likelihood
that the spot rate will exceed the strike price,
creating intrinsic value.
However, as the spot rate increases,
the value of a put option decreases.
This is because there is a lower likelihood
that the spot rate will fall below the strike price
and, hence, no intrinsic value.
Strike prices have an inverse relationship
with call options,
and a positive correlation with put options.
As the strike price increases,
the value of a call option decreases.
This is because there is a lower likelihood
that the spot rate will exceed the strike price
and, hence, no intrinsic value.
However, as the strike price increases,
the value of a put option increases.
This is because there is a higher likelihood
that the spot rate will fall below the strike price,
creating intrinsic value.
Volatility has a positive correlation
with both call options and put options.
As the volatility of the underlying asset's price increases,
the value of both call options and put options increases.
The is because there is a higher likelihood
that the spot price will move favourably
against the strike price, creating intrinsic value.
Time to expiration also has a positive correlation
with both call options and put options.
As the time to expiration increases,
the value of both call options and put options increases.
This is because there is a higher likelihood
that the spot price will move
favourably against the strike price,
creating intrinsic value.
Interest rates have a positive correlation with call options
and a negative correlation with put options.
As interest rates increase,
the value of a call option increases.
This is because a call option buyer is prepared
to pay more for the call option,
because they would prefer to delay the purchase
of the underlying asset
while they can invest spare funds at the higher rate.
However, as interest rates increase,
the value of a put option decreases.
This is because a put option buyer is less prepared
to pay more for the put option,
because they would prefer to sell the underlying asset now
to invest the proceeds at the higher rate.
To recap, option prices represent the sum
of intrinsic value and time value.
At expiry of the option
only intrinsic value remains.
Option prices are determined by five key factors:
spot rates, strike prices,
volatility, time to expiration, and interest rates.