Channels such as NDTV profit and CNN-IBN always have numbers running across the screen from right to left round the clock. These are nothing but option premiums. Simply put, Option premium is the amount per share that the option buyer pays to the seller. In finance, an option is a derivative that denotes a contract between two parties for a future transaction on an asset at a reference price. The buyer of the option gains only the right or the ‘stake’ in the company, but not the obligation to engage in its day to day activities. The option premium (intrinsic value) is primarily affected by the difference between the stock price and the strike price. Stock price is the current value of the asset whereas strike price is the price at which the option was, at the time of drawing the derivative, fixed to be bought or sold. The volatility and the remaining time of the option will have a great impact on the option premium. To some extent, factors such as interest rates, market conditions and the dividend rate of the underlying stock too affect the option premium.
Exercising the security mens the process involved in activating the option and then trading on the security. Most options have an expiration date. The option has to be exercised before the expiration date mentioned therein or else it will become void. On exercising the option, the seller collects the payment from the buyer. An option, once bought by an original buyer (first buyer) can be further sold to another party (secondary trading).
Based on how these options are secondary traded, they can be divided into Exchange traded options and Over-the-counter options. The former, i.e. exchange traded options have standardized fool-proof contracts which are settled through a clearing house with the fulfillment of the option guaranteed by the credit of the exchange. Accurate pricing models will be available for most f the contracts which are stadardised. In the latter method, i.e. Over-the-counter method, even options that are not listed in a stock exchange can be traded between two private parties. The terms of an OTC option are not restricted and may be customized to meet any business need. As a corollary, the option fulfillment is not as guaranteed as in the former case. The most commonly traded options over the counter are interest rate options, currency cross rate options and options on swaps. Another important class of options, exercised particularly in the U.S., is employee stock options, which are options awarded by a company to their employees as a form of incentive compensation.
There are two components to options premium: intrinsic value and time value. Intrinsic value is determined, as stated earlier, by the difference between the current trading price and the strike price. Only ‘in-the-money options’ have intrinsic value; ‘Out-of-the-money options’ don’t. ‘In-the-money’ indicates the ‘moneyness’ of an option. A ‘call’ option is said to be ‘in-the-money’ when the strike price is below the current trading price of the underlying security. However, a ‘put’ option is ‘in-the-money’ when the strike price is above the current trading price of the underlying security. An option’s time value is dependent upon the amount of time remaining to exercise the option. The time value of an option decreases as it approaches its expiration date and becomes futile after that which is known as time decay. For ‘in-the-money options’, subtracting the intrinsic value from the option price will give the time value. However, for ‘out-of-the-money’ options, since the intrinsic value is zero, time value is simply equal to option price.
A peculiarity with the options is their naming jargon. Options are named or classified according to their properties. Some of the classifications of options are European, American, Bermudan, Barrier, Exotic and Vanilla. European option can be exercised only on expiration. American option can be exercised only on a trading day. Bermudan option can be exercised only on specific dates (on or before expiration). A Barrier option refers to any option with the requirement that its underlying security price should pass a certain ‘barrier’ before it can be exercised. Exotic and Vanilla options are mutually contrasting, with the former being any broad category of options that may include financial structures and the latter simply not belonging to the former.