Trade efficiently! What impacts option premium and how

Every once in a while it makes sense to go back to the basics and re-evaluate the mechanics of the very instruments that help us make money. So, in this discussion let us understand what impacts the options in what way and draw learnings out of them.

To understand this though, we need to first list down the key inputs used to price an option because these inputs would eventually turn into the list of determinants for change in option premium.

In NIFTY Option Chain , BankNifty Option Chain , Reliance Option Chain , etc. premium is an output of 5 inputs1. Underlying Price2. Strike Price3. Time to Expiry4. The volatility of the Underlying 5. Risk-free Rate of Interest

— Underlying Price : The first one is rather straightforward and easiest to understand. I remember talking to many fellow traders when they were first introduced to options. The definition was quite simple - Call means Bullish Instrument and Put means Bearish Instrument.

Taking that very basic but accurate analogy forward for this one, if Underlying Price goes up Call Premium would go up and if Underlying Price goes down Call Premium would go down. The situation is exactly the opposite for Put options Other Things Being Equal (ceteris paribus).

Other Things Being Equal means this impact is accounting for no change in other factors affecting premium.

Learning: Just like trading the underlying make sure we are in the right instrument (Call/Put) while trading a directional move by buying option.

— Strike Price: To understand the role of a strike price we would be twisting the representation a bit here. Instead of how strike price impacts premium, let us understand how premium behaves with exactly the same underlying move for two different strikes.

So, in case of Calls higher the strike, the less sensitive it would be to the underlying move. On the Put side, lower the Put strike and lesser sensitivity it turns to the same underlying move.

At the same time, Higher Strike Calls and Lower Strike Puts command fewer premiums than their counterparts.

Learning: Align the level of confidence to the Strike Price. Lower the confidence Higher would be the strike of selected Call or lower would be the strike of Put.

Remember, less sensitivity means less profits but also less losses.

— Time to Expiry : Time to expiry is by far the most understood determinant of option premium. More the time to expiry, more would be the premium. As the time to expiry reduces the premium reduces - once again with other things being equal. This impact of time is similar for both Call and Put.

Learning: Always have a time stop loss along with stop loss in the underlying while buying options because the right direction will definitely pull option premium up but a longer holding period will start showing meaningful pushdown, making the trade unattractive.

— Volatility : The volatility referred here is ideally a volatility figure of the underlying which would be drawn out of historical price movements. When it comes to option pricing though, there are references to the historical volatility but this input of volatility is more of an expectation of volatility.

Nonetheless, it’s a direct relationship here as well. Higher the volatility, higher would be the premium of both Call and Put and vice versa.

Learning: If there is an expected drop in volatility expect and account for a drop in premium despite no change time or underlying price. This generally happens in times of known events like corporate results, policy decisions, etc. So, if we are going through an event holding on to the option, expect and account for a fall in premium once the outcome of the event is announced.

— Risk-free Rate of Interest: This is one factor that is least talked about and least impacting. Considering the smaller horizons (1 week to 1 month) of popularly traded options. This factor does not impact the option premiums much, so no need to account for it either.

But in case there is an inclination to participate in longer-term option, the relationship is direct in terms of Call premiums and indirect in terms of Put premiums.

Learning: Rise in interest rate would result in higher Call premium and lower Put premiums other things being equal.

These are the basic determinants of option premium. Always have these relationships of premium and its determinants at the back of the mind to trade more efficiently.

The author is CEO & Head of Research at Quantsapp.

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