Question

The mechanics of options markets: (derivatives and risk management)

Explain the following concepts: 1. Intrinsic (IV) and extrinsic (EV) values of an option 2.   How IV and EV relate to premium and moneyness 3.   Payoff graphs and net payoff graphs
4. Premium vs. theoretical value

Answer 1

1. Intrinsic (IV) and extrinsic (EV) values of an option

Intrinsic value is the difference between the Strike price of the option and the underlying spot price. This is used by investors to roughly find out how much the option is in\out the money.

• Intrinsic value (for call) = Spot - Strike
• Intrinsic value (for put) = Strike - Spot

Extrinsic value or Time value is nothing but the value of the option influenced by other factors like time, volatality, rate of interest rate etc.. Extrinsic value is usually high when the option has more days left to maturity.

2.   How IV and EV relate to premium and moneyness

Intrinsic value + extrinsic value = Option value

Below representation will make the relationship clear.

• Spot price = 10 & Strike = 9
• Intrinsic value = Spot - Strike = 1
• Extrinsic value = 0.3 (this involves other factors like time to maturity,volatality & IR

Option price = Intrinsic value + extrinsic value = 1.3

Premium of In the money options> At the money options > Out of money options

OTM option have less intrinsic value + no time value, hence they usually tend to have a price closer to Zero.

3. Payoff graphs and net payoff graphs

Pay off graphs = depicts the Individual Option profits\loss

Net pay off graphs = depicts the gain\loss of the entire position or strategy, break even point etc.

To understand better please consider the below example of a straddle technique.

Straddle = Buy Call + Buy Put (both with same strike prices).

• Maximum loss = Premium paid for the options
• Maximum gain = Unlimited

Blue line & Red line = Payoff graphs

Black line = Net pay off graph

4. Premium vs. theoretical value

Premium = the price paid by the buyer to seller to enjoy the right of exercising it at any time until expiry.

Theoretical value = Mathematical value derived from option valuation models like black scholes.

But why theorectical value is calculated at first place? for Exchange traded derivatives the premium is readily available in the market, but for OTC options there is no premium readily available as these are private agreements between two parties. Hence these parties use the option valuation model to calculate the fair value(theoretical) of the option and exchange cash flows based on it.

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