1. What is Option Pricing?

Option pricing involves calculating the fair value of an options contract. The premium of an option consists of two main components: intrinsic value and time value. Understanding these components helps traders make informed decisions in the derivatives market.

2. How Does the Calculator Work?

The calculator uses the fundamental option pricing formula:

Where:

• Intrinsic Value — The immediate exercise value of the option
• Time Value — The additional premium for time remaining until expiration
• Call Option Intrinsic Value = max(Spot Price - Strike Price, 0)
• Put Option Intrinsic Value = max(Strike Price - Spot Price, 0)

Explanation: Intrinsic value represents the profit if exercised immediately, while time value accounts for the probability of the option becoming more profitable before expiration.

3. Importance of Option Pricing

Details: Accurate option pricing is crucial for identifying mispriced options, managing risk, developing trading strategies, and understanding market sentiment. It forms the basis for sophisticated pricing models like Black-Scholes.

4. Using the Calculator

Tips: Enter the current spot price of the underlying asset, the strike price of the option, select the option type (call or put), and input the time value component. All monetary values should be in Indian Rupees (₹).

5. Frequently Asked Questions (FAQ)

Q1: What is the difference between intrinsic and time value?
A: Intrinsic value is the real, tangible value if exercised now, while time value represents the potential for future price movements before expiration.

Q2: How is time value determined in real markets?
A: Time value is influenced by time to expiration, volatility, interest rates, and dividend expectations. It decays as expiration approaches (theta decay).

Q3: What happens when an option has no intrinsic value?
A: Options with no intrinsic value are "out-of-the-money" and their entire premium consists of time value only.

Q4: Why do options have time value?
A: Time value exists because there's a probability that the option could move into profitability before expiration, giving it potential value.

Q5: How does volatility affect option pricing?
A: Higher volatility increases time value because there's greater potential for large price movements, making the option more valuable.