Option premium Understanding Fluctuations and Profit Potential in Options Trading

A quick note on Premiums

This snapshot depicts the intraday behaviour of a BHEL 230 European Call Option (CE) premium on April 30th 2015. The data is in the red box and below that I have pointed out its price info. It began at Rs.2.25, went up to Rs.8/- and finished at Rs.4.05/- by day’s end.

Ponder this: the premium on the day soared by 350%, from Rs.2.25/- to Rs.8/-, and it closed up at a comparatively modest 180%, from Rs.2.25/- to Rs.4.05/-. Such fluctuations are not uncommon in options trading, so don’t be shocked.

Assuming you have managed to capture just 2 points when trading this particular option intraday, this will generate an attractive Rs.2000/- in profits as each lot is worth 1000 (highlighted by the green arrow). This is very common when it comes to trading premiums as traders generally do not hold onto their option contracts until expiry, but they try and take advantage of short-term movements in premiums by initiating and closing trades quickly (intraday or within a few days).

It is not unusual to experience returns of 100% or more through options trading, but be mindful that such consistent gains can only be made with a thorough understanding of this instrument.

This is IDEA Cellular Limited’s option contract. It has a strike price of 190 that expires on 30th April 2015, and the type is a European Call Option, noted in the blue box. Below this lies the OHLC data, which is highly intriguing.

If you had sold the 190-call option intraday at an opening price of Rs. 8.25/- and managed to capture a minimum low of Rs. 0.30/-, you could have gained a profit of Rs. 4000/- with a lot size of 2000. This significant profit would be enough to treat your partner to a dinner at Marriot.

I am emphasising that most traders trade options to benefit from the changing premiums. They usually don’t hold until expiry. There are rare cases where I do, normally option writers tend to keep the contracts running until expiry rather than purchasers. This is because if you have sold an option for Rs. 8/- then you will get the whole premium received that is Rs. 8/- only on expiration.

Having said that traders like to trade just the premiums, you may have some questions about it. Why does the premium vary? What is the cause for the change in premium? Can we forecast the future movement of the premium? Who determines the valuation of a specific option?

Questions about options form the basis of option trading. If you’re able to fully understand these fundamental components, it can be a stepping-stone to becoming a proficient trader in this area.

You can think of the option’s premium as a ship sailing in the sea. Its speed is determined by a number of forces, such as wind speed, water density, pressure, and its own power. Some of these forces increase or reduce the speed and it eventually finds an optimal rate. To understand why the premiums, vary so much, you need to consider all four forces acting on them.

The ‘Option Greeks’ are responsible for the variation in the option premium. Some can boost it while others bring it down. These opposing forces are factored into the ‘Black & Scholes Option Pricing Formula’, which subsequently yields the premium of the option.

Envision this – the Option Greeks sway the option premium yet are regulated by the markets. Since markets shift moment by moment, the Option Greeks also alter, thus altering the option premiums in turn!

In this course, we will learn to identify the various forces that drive pricing of options, how these forces are affected by market conditions and how Option Greeks further modify the option premium.

So, the end objective here would be to be –

  1. To gain an understanding of how Option Greeks impact premium pricing 
  2. To understand how premiums are determined by considering Option Greeks’ influence
  3. Finally, keeping the Greeks and pricing in perspective, we need to select strike prices to trade smartly

Before attempting to learn the option Greeks, we must first understand the concept of “Moneyness of an Option”. We will cover this in detail in the upcoming chapter.

We anticipate that the topics to come may be more complicated, however we will strive to keep them simple. In order for you to be successful, it is essential that you understand everything we have worked on already.