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The main purpose for making an investment is to earn profit. The Capital market system
is comprised of different markets in which an investor can invest. One can invest in
shares, share indices, treasury bills, bonds, foreign exchange, and commodities. There
have been rapid changes in corporate, bank and investment finance in recent years due
to which a new set of financial instruments have come into existence. Derivative is a
financial instrument whose value is based on the underlying security and assets.
Derivatives can be broadly classified into Forward, Future, Swaps and Options, Forward
rate agreements. Options are one of the most popular because they provide limited risk
along with unlimited profit to an investor.


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In finance, an option is a type of financial instrument classed as derivative because its
price is determined by the fluctuations in the underlying assets. An option gives its
holder the right, but not the obligation, to buy or to sell some asset (underlying) on or
before the options expiration at an agreed price, the strike price. An option, just like a
stock or bond, is a security. It is also a binding contract with strictly defined terms and
properties
In return for granting the option, the seller collects a payment (the premium) from the
buyer. Granting the option is also referred to as "writing" of the option. In simple words,
the buyer of the option is the one who pays the premium and seller of the option is the
one who receives the premium. In operational terms, the seller/writer of the option runs
the risk of loss as the seller receives the option premium from the buyer of the option.
(Brealey, Richard A, Myers, Stewart 2003- Chapter 20)

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%&  c $ The European Option can be exercised only at the expiration
date or on date of maturity.

'&  c $ The American Option can be exercised at any time on or
before the expiration date i.e. it can be exercised throughout the life of the
Option. Therefore they are more flexible options as compared to European
options.

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A ""   gives the buyer of the option the right but not the obligation to buy the
underlying at the strike price within a specific period of time (Brealey, Richard A, Myers,
Stewart 2003-Chapter 20). Calls are similar to having a long position on a stock. The
one who buys the call hopes that the price of stock will increase substantially before the
option expires.

A    gives the buyer of the option the right but not the obligation to sell the
underlying at the strike price within a specific period of time (Brealey, Richard A, Myers,
Stewart 2003-Chapter 20). The one who buys the put hopes that the price of the stock
will fall before the option expires.
If the buyer chooses to exercise this right, the seller is obligated to sell or buy the asset
at the agreed price. The buyer may choose not to exercise the right and let it expire.
Every financial option is a contract between the two counterparties with the terms of the
option specified in a term sheet.

The # """ 

# """
Consider an example where an investor Mr. A buys a European call option with a strike
price of Rs 100 to purchase 100 shares of XYZ Co. The current market price of the
stock is Rs 96, the expiration date is after 1 month and the option¶s purchase price is Rs
. The initial investment is Rs 00. In this case because it is a European option, Mr. A
can exercise the option only at the expiration date.
If the stock price on the date of expiration is below Rs 100, Mr. A will clearly choose not
to exercise the option. As there is no point in buying a share for Rs 100 that has a value
of less than Rs 100. In this case Mr. A will lose the initial investment Rs 00 i.e. the total
premium paid.
If the stock price at the date of expiration goes above Rs 100, Mr. A will choose to
exercise the option. Mr. A will exercise the option because he will earn profit. Suppose if
the stock price is Rs 120, Mr. A will be able to buy 100 shares of Rs 100 each. Now if
Mr. A sells the shares immediately he will make a profit of Rs 1 (Rs 20 profit ± Rs  the
premium) on each share. The total profit that Mr. A will make will be Rs 100 (100x1).

# " 

Consider an example where Mr. B buys a European put option with a strike price of Rs
90 to sell 100 shares. Suppose the current stock price is Rs 8, the expiration date of
the option is after 4 months and the price of the option i.e. premium is Rs . The initial
investment is Rs 00. In this case because it is a European option, Mr. A can exercise
the option only at the expiration date.
If the stock price at expiration date is below Rs 90 then Mr. A will choose to exercise the
option. Suppose if the current market price is Rs 70, Mr. A will sell the shares for Rs.90
each. The total profit that he will make is Rs 1 (Rs 20 profit ± Rs  premium). The total
profit that Mr. B will make is Rs 100 (100x1).

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(Khan and Jain, 4th Edition: .1) explains various terms associated with options:

*c $ Is the one, who by paying the option premium buys the right to
buy/sell securities. He has no obligation to exercise his option.

   c $ Is the one who receives the option premium and is thereby
obliged to sell/buy the securities if the buyer exercises the option on him.

c  + $ The price that the option buyer pays to the option seller is
known as option price or option premium.

# $ The date specified in the option contract by which the option can be
exercised. It is known as the exercise date or the maturity date. Options contracts
specify the expiration date as part of the contract specifications. After the expiration
date the option is no longer in existence, namely the contract to the rights of buying or
selling a stock has become void.

 $ The price specified in the options contract at which the buyer can exercise
his right to buy or sell the securities is known as the strike price or exercise price.
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(A.N. Sridhar 2007, 9-7)


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1. #.
 c ! are also called as µlisted options¶. They are a class of
exchange traded derivatives. Exchange traded options have standardized contracts
and are settled through a clearing house with fulfillment guaranteed by the credit of
the exchange. Since the contracts are standardized, they provide real time access to
information online which helps in executing the order. Exchange traded options
include ( http://www.iseoptions.com):

1. Stock Options
2. Commodity Options
3. Bond Options and other Interest Rate Options
4. Stock Market Index Options or Index Options and
. Options on Futures contracts

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OTC options are traded between two private parties and are not listed on an exchange.
In OTC market, financial institutions, corporate treasurers and fund managers trade
over the phone. The options in the OTC market are often structured by financial
institutions to meet the precise needs of their clients. Sometimes this involves choosing
exercise dates, strike prices and contract sizes that are different from those traded by
the exchange. In general, at least one of the counterparties of an OTC option is a well-
capitalized institution. Option types traded over the counter include:
È Interest Rate Options

Currency Cross Rate Options
 Options on Swaps or Swaptions
(Fabozzi, Frank j, 2002:471)



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There are two sides of every option contract .On one side is the investor who has taken
the long position i.e. the one who is buying the option. On the other side is the investor
who has taken a short position i.e. the one who is writing the option. The writer of an
option receives the premium upfront but has unlimited loss in future. The buyer pays
premium upfront but has limited loss in future. (John C. Hull 2009:181).
There are four types of position:

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It is a buy position taken by a trader who is bullish on the market/stock i.e. he expects
the price to go up. ³A trader who believes that a stock's price will increase might buy the
right to purchase the stock (a call option) rather than just buy the stock´. He would have
no obligation to buy the stock, only the right to do so until the expiration date. He would
therefore make money only when the price increases on the day of exercise. Also if the
price is below the strike price, he will prefer to buy directly from the market and hence
will not exercise the option thereby losing his premium (http://invest-faq.com).
.(. ""

 
³From the above graph it can be seen that if the stock price is below the strike price at
expiration, investor¶s loss will be only the premium paid for the option. A long call has
unlimited profit potential on the upside´ (Smith, B. Mark 2003).
 
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It is a sell position taken by a trader (also called as seller/writer) who is bearish on the
market/stock i.e. he expects the price to go down. These are considered as very risky
positions because the risk is unlimited.
The trader selling a call has an obligation to sell the stock to the call buyer at the buyer's
option. If the stock price decreases, the short call position will make a profit in the
amount of the premium. If the stock price increases over the exercise price by more
than the amount of the premium, the short call position will lose money, with the
unlimited loss (Smith, B. Mark 2003).

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It is a sell position taken by a trader who is bearish on the market/stock i.e. he expects
the price to go down. Here he has the right to sell the security/asset at strike price at
expiration. He would therefore make money only when the market price decreases
below strike price on the date of expiration. If the stock price at expiration is above the
strike price, he will not exercise and will lose his premium. (A.N. Sridhar, 2007:9-9).
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It is a buy position taken by a trader who is bullish on the market/stock i.e. the trader
expects the price to go up. He would therefore make money (to the extent of premium
collected) only when the price increases on expiration. Otherwise he would make
unlimited losses if the stock price at expiration is below the exercise price. He is under
the obligation of the buyer, and has to accept delivery of shares and pay the strike price
if exercised. (A.N. Sridhar, 2007:9-9).
 . 

It is useful to characterize a European option in terms of its payoff to the purchaser of

the option. The initial cost of the option is then not included in the calculation. The strike
price (K) and the final price (S) of the underlying asset, the payoff from the long position
in a European call option is:
max (S-K, 0)
This means that the option will be exercised if S>K and will not be exercised if S<K.
The payoff to the holder of a short position in a European call option is:
-max (S-K, 0) = min (K-S, 0).
The payoff to the holder of a long position in a European put option is:
-max (K-S, 0).
The payoff from a short position in a European put option is:
-max (K-S, 0) = min (S-K, 0) (John C. Hull 2009:182, 183).

   
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1. HEDGING
D.C. Patwari and Anshul Bhargava state that ³Hedgers are attracted to the derivative
market to reduce the risk that they already face. Virtually all industries and trades
affected by price fluctuations need to lock into the future price of their raw material or
product. This is possible through the futures market. Millers, traders and producers who
want to hedge their price risk but at the same time want to benefit from favorable price
movements can enter into option contracts. With option contact, hedgers get a locked ±
in price on a future date for buying or selling commodities´. Hedging like insurance
insures the investment in an option against a downturn. It can be used in a scenario, by
an investor who wants to take advantage of technology stocks and their upside, but also
wants to limit any losses. By using options, he will be able to restrict the downside i.e.
the loss while enjoying the full upside i.e. the profit in a cost-effective way
(http://www.financescholar.com/speculation-hedging.html).
Hedging a stock price
Consider an investor who owns 1000 Microsoft shares in May and share price is $24.
The investor is concerned about a possible share price decline in the next 2 months and
wants protection. The investor could buy the July put option contracts on Microsoft on
the Chicago Board Options Exchange with a strike price of $27..This would give the
investor the right to sell a total of 1000 shares for a price of $27.. If the quoted option
price is $1, then each option price is $1, then total cost of the hedging strategy would be
1000x$1= $1000. The stratergy costs $1000 but guarantees that the share can be sold
for at least $27.0 per share during the life of the option.
If the market price of Microsoft falls below $27.0 the options will be exercised and the
amount of $2700 will be realized when the cost of the option is taken into account the
amount realized is $2600.
If the market stays above $27., the options will not be exercised and will expire
worthless. However, in this case the investor will make profit because the value of the
shares he has will be above $2700. (John C. Hull 2009:11).

 '& SPECULATION
Speculation is betting the movement of a stock. The advantage of options is that you
are not limited to make profit only when the market goes up. Options can help investor
to make money not only when the price of the stock goes up, but when it goes down
side or even sideways (http://www.financescholar.com/speculation-hedging.html).
Options are risky because when you buy an option, you have to be correct in
determining not only the direction of the stock's movement, but also the magnitude and
the timing of the movement of the stock. To make profit, an investor must correctly
predict whether a stock will go up or down, and he has to be right about how much the
price will change as well as the time frame for it to happen. The investor also needs to
keep the amount of commissions that he will have to pay to the broker as well as the
cost of purchasing the option.
(http://www.financescholar.com/speculation-hedging.html)

# "$
Suppose that it is October and a speculator considers that a stock is likely to increase in
its value over the next 2 months. The stock price is currently $20, and a 2 months call
option with a $22.0 strike price is currently selling for $1. There are two possible
alternatives, assuming that the speculator is willing to invest $2,000. One alternative is
to purchase 100 shares; the other alternative is to purchase 2,000 call options (i.e., 20
call option contracts). Suppose that the speculator's hunch is correct and the price of
the stock rises to $27 by December.
The first alternative of buying the stock yields a profit of:
100 x ($27 - $20) = $700
However, the second alternative is far more profitable. A call option on the stock with a
strike price of $22.0 gives a payoff of $4.0, because it enables something worth $27
to be bought for $22.0. The total payoff from the 2,000 options that are purchased
under the second alternative is:
2,000 x $4.0 = $9,000
Subtracting the original cost of the options yields a net profit of:
$9,000 - $2,000 = $7,000
The options strategy is, therefore, 10 times more profitable than directly buying the
stock. An option also gives rise to a greater potential loss. Suppose the stock price falls
to $1 by December. The first alternative of buying stock yields a loss of
100 x ($20 - $1) = $00
Because the call options expire without being exercised, the options strategy would lead
to a loss of $2,000 i.e. the original amount paid for the options.
For a given investment, the use of options magnifies the financial consequences. Good
outcomes become very good, while bad outcomes result in the whole initial investment
being lost. (John C. Hull 2009:13)

& *
1 
The act of taking advantage of difference in price between markets is called as
arbitrage. Arbitrageurs are a third important group of participants in futures, forward,
and options markets. Arbitrage involves locking in a riskless profit by simultaneously
entering into transactions in two or more markets.
For example, if a stock is quoted on two different equity markets, there is the possibility
of arbitrage, if the quoted price in one market differs from the quoted price in the other.
Various option contracts are available in the NSE and the BSE in India. There has to be
parity in the prices of both put and call option in the same series; otherwise there will be
arbitrage opportunities. Similarly if options prices do not observe arbitrage restrictions,
there may be arbitrage opportunities since more than 21 contracts are available in Nifty
index options at any point of time and also in individual stock options. The Example of
arbitrage has been further explained in Put-call Parity Pricing Relationship. (D.C.
Patwari & Anshul Bhargawa 200:232).
 
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Buying a call option together with a short position in the underlying asset creates a
synthetic long put option. Buying a put option in conjunction with a long asset position
creates a synthetic long call option. In a market where arbitrage is possible among the
underlying asset and instruments with the same underlying, there exists a systematic
price relationship among the various assets that can be combined to create equivalent
synthetic assets (D.C. Patwari & Anshul Bhargawa 200: 207).
This pricing relationship is known as 'put-call parity'. It requires that the price of an
European put option on one share of stock that does not pay dividends should be equal
to the combined value of a call option on one share of the same stock with the same
strike price and time to expiration as the put option, combined with a short position of
one share of the underlying stock and a risk-less investment of an amount equal to the
present value of the strike price (D.C. Patwari & Anshul Bhargawa, 200: 207).
The equilibrium put option price is: P = C + K e-rt - S0
Alternatively, the equilibrium call option price should be:
C = P + S0 - K e-rt
Where,
P = Current market price of a European put option.
C = Current market value of a European call option.
r = Risk-less interest rate covering the life of the option.
t = Time to expiration of put and call option.
K = Strike price of both put option and call options.
S0 = Current market price of the underlying stock.
ST = Market price of the underlying stock at the expiration date.
e-rt = The present value factor. (D.C. Patwari & Anshul Bhargawa, 200:207).
 # "
We can derive a relationship between P and C. Consider the following two portfolios:
Portfolio A: One European call option plus an amount of cash equal to K e±rt.
Portfolio C: One European put option plus one share.
Both are worth
max (ST, K)
at expiration of the option. As the options are European; they cannot be exercised prior
to the expiration date. Therefore the portfolios have identical values today. This means
that:
C+ K e-rt ± P + S0 -------------------------------------------- (1)

This relationship is known as put-call parity. It shows that the value of a European call
with a certain strike price and exercise date can be deduced from the value of a
European put with the same strike price and exercise date, and vice versa.
If equation (1) does not hold, there are opportunities for arbitrage. Suppose that the
stock price is $31, the strike price is $30, the risk-free interest rate is 10% per annum,
the price of a 3 month European call option is $3 and the price of a 3 month European
put option is $2.2. In this case,
C + K e-rt = 3 + 30e-0.1x3/12 = $32.26 and

P + S0 = 2.2 + 31= $33.2.
Portfolio C is overpriced relative to portfolio A. An arbitrageur can buy the securities in
portfolio A and short the securities in portfolio C. The strategy involves buying the call
and shorting both the put and the stock, generating a positive cash flow of
-3 +2.2 + 31 = $30.2.
up front. When invested at the risk-free interest rate, this amount grows to
30.2e 0.1 x0.2 = $31.02
in 3 months. If the stock price at expiration of the option is greater than $30, the call wiIl
be exercised. If it is less than $30, the put will be exercised. In either case, the
arbitrageur ends up buying one share for $30. This share can be used to close out the
short position. The net profit is therefore:
$31.02 - $30.00 = $1.02
For an alternative situation, suppose that the call price is $3 and the put price is $1.
In this case,
C + K e-rt = 3 + 30e-O.1x3/12 = $32.26 and
P + S0 = 1+ 31 = $32.00
Portfolio A is overpriced relative to portfolio C. An arbitrageur can short the securities in
portfolio A and buy the securities in portfolio C to lock in a profit.
The example simply states that arbitrage opportunities exist when put--call parity does
not hold. When Stock price = $31; interest rate = 10%; call price = $3. Both put and call
have a strike price of $30 and 3 months to maturity. (John C. Hull, 2009:208 and 209).
Put ±call parity holds only for European options. However, it is possible to derive some
results for American option prices. It can be shown when there are no dividends,
S0 - K<= C - P <= S0 ± Ke-rt. (John C. Hull, 2009:208 and 209).
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An option premium has two elements - Intrinsic Value and Time Value. An options value
will be the maximum when it is in-the-money. In-the-money, out-of-the-money or at-the-
money situations are dependent on the spot price of an asset. Therefore, a call option
will have more value if the spot price is high. The value of a put option is the maximum
when the spot price is the lowest. (D.C. Patwari & Anshul Bhargawa, 200:19).
In other words the closer the market price is to the strike price, the rate of change will be
the highest. For strike prices farther away from the market price, the rate of change of
option premium will be lower.

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The effect of strike price on option will be exactly opposite of the effect of the Current
price of the stock. For call option as strike increases (decreases), the value of the call
decreases (increases). For a put option as the strike price increases (decreases), the
value of the put increases (decreases) (http://accountingforinvestments.com).

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With more time there is more uncertainty. More the time to expiry, greater are the
chances that there would be fluctuation in the price of the underlying to the advantage
of one of the parties to the contract. Hence more the time, higher would be the time
value of the premium. The option¶s price is directly related to the time remaining till the
expiration of the option contract. The buyer of an option stands to gain if the option
contract finishes in-the-money ± and greater are the chances that it would be so if there
is more time to expiry. It should be noted that as the time to expiration of the option
contract decreases, the value of the option would erode.
If an investor buys an option that is three months away from expiration, it will be more
expensive than a similar option that is only five days from expiration. As time passes,
option contracts lose value. If the investor buys an option that is three months away
from expiration and holds it until there are only five days for expiration, there will be a
significant premium loss due to time depreciation assuming the price of the underlying is
more or less constant (http://accountingforinvestments.com).

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As interest rates increase, the expected growth rate of the stock price also increases,
but the present value of any future cash flow received by the holder of the option
decreases. These two factors decrease the value of a put option. Therefore, the value
of a put option decreases with an increase in the interest rate. In the case of calls, the
present value of the discounted cash flow decreases the present value of the strike
price. With the lower strike price, the value of the call option increases. Thus, with an
increase in the interest rate, the value of a call increases. (D.C. Patwari & Anshul
Bhargawa, 200:19).

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The volatility of a stock price or index movement is a measure of the uncertainty about
the movement of the future stock price / index. With the increase in volatility, chances
are that the price movement in stock will increase. The owner of a call or put option
benefits from the price movement as he has one side risk only. However, with more
volatility, the risk of the option writer increases as the chances of the option going in-
the-money rises. The effect of volatility on options is always positive, which means, with
an increase in volatility, the option value or premium goes up. Someone who bought
options earlier would be benefited to the detriment of someone who previously sold
options. Buying options prior to such volatility expansion has a high probability of
success. (D.C. Patwari & Anshul Bhargawa, 200:197).

6& 4
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Dividends or expected dividends of an underlying stock impacts in a peculiar way the
pricing of its derivative be it futures or options. The reason being that once the
underlying goes ex-dividend, the market rate of the underlying gets reduced exactly by
the amount of dividend declared per share. As a result of this the future market rate of
the underlying should be discounted to the extent of the dividend per share.
To understand fully the impact of dividends on the option pricing, you should know that
dividends are paid only to the holder of the underlying on the record date. The holders
of call options on the same underlying stock however are not eligible to get any
dividends. Hence, when dividend is declared by the company, the holders of the
underlying stock are benefited to the extent of the dividend declared, while the holders
of the call option are deprived of the same. This is reflected in the price of the call
option.
Similarly, short sellers of an underlying stock that carries a dividend component are
required to pay the dividend to the owner from whom they borrowed the stock which
offsets the interest they receive for the short position they hold. This has the effect of
increasing the price of a put option whenever dividend is declared on the underlying
stock.
In short, an increase in the dividend of the underlying stock has the effect of reducing
the call prices and increasing the put prices. A reduction in the dividend has the effect of
increasing the call prices and decreasing the put.
(http://accountingforinvestments.com).

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Variable European European American American
Call Put Call Put
Current Stock + - + -
Price
Strike Price - + - +
Time to ? ? + +
Expiration
Volatility + + + +
Risk-Free Rate + - + -
Amount of Future - + - +
Dividends

Here,
³+´ indicates that an increase in the variable causes the option price to increase;
³-´ indicates that an increase in the variable causes the option price to decrease;
³?´ indicates that the relation is uncertain. (John C. Hull, 2009:203).


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An option is at-the-money if the strike price is the same as the spot price of the
underlying security on which the option is written. An at-the-money option has no
intrinsic value, only time value. The option is said to be at-the-money when it leads to
zero or no cash flow (no profit no loss) to the holder if it is exercised immediately.

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An in-the-money option has positive intrinsic value as well as time value. A call option is
in-the-money when the strike price is below the spot price. A put option is in-the-money
when the strike price is above the spot price. The option is said to be in-the-money
when it leads to a positive cash flow (profit) to the holder if it is exercised immediately.

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An out-of-the-money option has no intrinsic value. A call option is out-of-the-money
when the strike price is above the spot price of the underlying security. A put option is
out-of-the-money when the strike price is below the spot price. The option is said to be
out-the-money when it lead to a negative cash flow (loss) to the holder if it is exercised
immediately.

(Khan and Jain, 4th Edition: .1).


 
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(Khan and Jain, 4th Edition: .8) mentions that the ³intrinsic value of an option is the
amount the option is in-the-money (ITM), that is, the excess of share price over the
exercise price. If it is out-the-money (OTM), i.e. the exercise price is higher than the
share price and its intrinsic value is zero.
Time Value of an option is the difference between the option premium and its intrinsic
value. The longer the time of expiration, the greater is an option¶s time value, other
things being equal. At expiration, an option would have no time value.´
The option price is constituted of two price components, the intrinsic value and the time
value.
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The intrinsic value of an option is the difference between the actual price of the
underlying security and the strike price of the option. The intrinsic value of an option
reflects the effective financial advantage which would result from the immediate
exercise of that option. The intrinsic value of an option is that part of the option premium
which represents the extent to which the option is in-the-money. Therefore an option,
which is Out-of-the-money, has zero intrinsic value.
For example, the intrinsic value of Rs 120 December put for stock when December
stock price i.e. spot are trading at Rs 100 is Rs 20 (Rs 120 strike price ± Rs 100
underlying futures price). The holder has the right to sell at Rs 120 while the market is
trading at Rs 100, so the Rs120 put has a ³built-in´ value of Rs 20. In this case, the Rs
120 put is said to be ³in-the-money´ by the amount of its intrinsic value (Rs 20). If
December stock price i.e. spot were trading at Rs 130, the Rs 120 put would have no
intrinsic value and the Rs 120 put would be classified as ³out-of-the-money.´ Intrinsic
value is never quoted as less than zero. Similarly, if December spot were at exactly Rs
120, an Rs 120 option (put or call) would be classified as ³At-the-money.´
Condition Call Put
Strike price < underlying In-the-money Out-of-the-money
security price Intrinsic value>0 Intrinsic value = 0
Strike price > underlying Out-of-the-money In-the-money
security price Intrinsic value = 0 Intrinsic value>0
Strike price = underlying At-the-money At-the-money
security price Intrinsic value = 0 Intrinsic value = 0
Note: Intrinsic value can never be negative.

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Time value of the option, which is also called extrinsic value of the option, is the
quantification of the probability of the change in the underlying price that determines the
value of the option during the remaining time until expiration. It is determined by the
remaining lifespan of the option, the volatility and the cost of refinancing the underlying
asset (interest rates). Mathematically, the time value of the option is equal to the
difference between the option premium and the intrinsic value. Thus if an option is Out-
of-the-money option, the entire premium paid is the time value of the option.

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An option that is ATM or OTM will have the entire premium as time value. Usually
maximum time value exists when the options are ATM. The longer the time to
expiration, the greater is an option¶s time value, all else is equal. At the expiration the
option shouldn¶t have any time value.
One can make entry and exit decision based upon the time value of options by tracking
option theta.
For example, if Rs 120 December put for stock sold for Rs 2 premium when December
share price was trading at Rs100, the put would have time value of Rs  on each stock
(Rs 2 premium ± Rs 20 intrinsic value = Rs  time value). Suppose if it is for 1000
stocks the total cost of this put option would be Rs 2000 (2 x 1000 stocks) plus a
commission charge. Of this amount, Rs 20000 would be the intrinsic value and Rs 000
the time value. For options with no intrinsic value, the entire premium equals time value.
Suppose that in July Rs 120 December put for stock with a share price of Rs 130 is
offered for Rs 2 per stock at the same time the December futures stock price is quoted
at Rs 100. The option is Rs 10 out-of-the-money and has no intrinsic value. Even so,
the put option has a time value of Rs 2 per stock. The premium of Rs 2 represents
the risk that the seller still has that the option could expire in-the-money.
Why would anyone pay for something that has no intrinsic value?
It has value because the option still has 4 months before expiration in November, and
during that time, the option buyer and seller knows the underlying futures price could fall
below the Rs 130 strike price. If the December share price were to fall below Rs 9
(strike price of Rs 120 minus premium of Rs 2), the holder of the put option would be
surely profit. For a December futures price between Rs 9 and Rs 119, the put option
buyer could recover all or a portion of the initial premium cost.