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Understanding the Options Premium
Investors love options because they enhance dozens of market strategies. Think a stock is going to rise? If you’re right, buying a call option gives you the right to buy shares later at a discount to the market value, profiting from the rise. Want to lower risk if your stock unexpectedly plummet? Acquiring a put option gives you the ability to sleep easy, knowing you can sell it later at a predetermined price and limit your losses.
Options can open the door to big gains or provide a safeguard against possible losses. And, unlike buying or shortselling shares, you can obtain a significant position with modest upfront capital. Whether you’re buying or selling these contracts, understanding what goes into an option’s price, or premium, is essential to longterm success. Bottom line: the more you know about the premium, the easier it will be to recognize a good deal or back out of a transaction because the odds are against you.
Intrinsic Value
There are two basic components to an option’s premium. The first is the contract’s intrinsic value, which signifies the difference between the strike or exercise price (the price you can buy or sell an underlying asset) and the asset’s current market value.
For example, you buy a call option for XYZ Company with a strike price of $45. If the stock is currently valued at $50, the option has an intrinsic value of $5 ($50 – $45= $5). In this case, you could buy the call and exercise it right away, reaping at $500 profit ($5 x 100 shares) This known as in the money.
However, if you buy a call option for XYZ with a strike price of $45 and current market value is only $40, there is no intrinsic value. That is known as being out of the money or under water.
The second component of an option’s premium now comes into play, detailing the length of the contract.
Time Value
Your options contract may be out of the money but eventually have value due to a significant change in the underlying asset’s market price. This is known as the contract’s time value. Roughly translated, it signifies whatever price an investor is willing to pay above the contract’s intrinsic value, in hopes the investment will eventually pay off.
For example, you buy the XYZ call option with a strike price of $45 and the underlying plunges to $40. You’re now out of the money but, in a month or two, the stock might rally to $50 and generate a $5 per share profit.
The option’s pricing includes your bet the stock will pay off over time. If you bought a call option for $45 and it had an intrinsic value of $5 (the stock was selling at $50), you might be willing to pay an extra $2.50 to hold the contract, expecting the underlying to add to gains. That would make the option’s premium $7.50 ($5 intrinsic value + $2.50 time value = $7.50 premium).
The option’s premium is constantly changing, depending on the price of the underlying asset and the amount of time left in the contract. The deeper a contract is in the money, the more the premium rises. Conversely, if the option loses intrinsic value or is out of the money, the premium falls.
The amount of time left in the contract also affects the premium. For example, the premium will drop as the contract gets closer to expiration, other factors being equal.
Measuring Volatility
While premiums tend to decline as expiration nears, the pace of the decline can vary considerably. This time decay marks a major component in the contract’s time value computation.

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You’re probably not going to pay a large sum for a blue chip’s call or put in the 30day window before expiration because odds for large scale price movement are limited in this relatively short period. Consequently, its time value will taper off well ahead of expiration.
Option premiums for lower capitalized securities, like hot growth stocks, tend to decay more slowly. With these instruments, odds for an out of the money option reaching the strike price are substantially higher, so the option holds its time value longer.
Due to these variations, the option trader should measure the stock’s volatility before placing a bet. One common way to accomplish this task is by looking at the equity’s standard deviation. Based on historical data, standard deviation measures the degree of movement up and down in relation to the mean price. A lower number indicates a relatively stable stock i.e. one that usually commands a smaller options premium.
Another way to gauge volatility is by determining its beta, or comparing the stock’s fluctuations to the market as a whole. A beta above 1 represents an equity that tends to rise and fall more than the S&P 500 or another broad index. This propensity for wider range price movement means the related options contracts will usually carry a higher price tag. An equity with a beta less than 1 is comparatively stable and thus likely to carry a smaller option premium.
These yardsticks are by no means perfect because a stock’s past performance doesn’t always predict future results. In addition, onetime events can make stocks look more unpredictable than they really are. However, volatility measurements can be very useful in determining a company’s price stability.
The Bottom Line
Options support a variety of market strategies for the seasoned investor but they do carry risks. A solid understanding of pricing factors, including volatility, increases the odds they’ll pay off with higher returns.
How and Why Interest Rates Affect Options
The US Federal Reserve is expected to raise the interest rates in the coming months. Interest rate changes impact the overall economy, stock market, bond market, other financial markets and can influence macroeconomic factors. A change in interest rates also impacts option valuation, which is a complex task with multiple factors, including the price of the underlying asset, exercise or strike price, time to expiry, riskfree rate of return (interest rate), volatility, and dividend yield. Barring the exercise price, all other factors are unknown variables that can change until the time of an option’s expiry.
Which Interest Rate for Pricing Options?
It is important to understand the right maturity interest rates to be used in pricing options. Most option valuation models like BlackScholes use the annualized interest rates.
If an interestbearing account is paying 1% per month, you get 1%*12 months = 12% interest per annum. Correct?
No!
Interest rate conversions over different time periods work differently than a simple up (or down) scaling multiplication (or division) of the time durations.
Suppose you have a monthly interest rate of 1% per month. How can you convert it to annual rate? In this case, time multiple = 12 months/1 month = 12.
1. Divide the monthly interest rate by 100 (to get 0.01)
2. Add 1 to it (to get 1.01)
3. Raise it to the power of the time multiple (i.e., 1.01^12 = 1.1268)
4. Subtract 1 from it (to get 0.1268)
5. Multiply it by 100, which is the annual rate of interest (12.68%)
This is the annualized interest rate to use in any valuation model involving interest rates. For a standard option pricing model like BlackScholes, the riskfree oneyear Treasury rates are used.
It is important to note that changes in interest rates are infrequent and in small magnitudes (usually in increments of 0.25%, or 25 basis points only). Other factors used in determining the option price (like the underlying asset price, time to expiry, volatility, and dividend yield) change more frequently and in larger magnitudes, which have a comparatively larger impact on option prices than changes in interest rates.
How Interest Rates Affect Call and Put Option Prices
To understand the theory behind the impact of interest rate changes, a comparative analysis between stock purchase and the equivalent options purchase will be useful. We assume a professional trader trades with interestbearing loaned money for long positions and receives interestearning money for short positions.
 Interest Advantage in Call Option: Purchasing 100 shares of a stock trading at $100 will require $10,000, which, assuming a trader borrows money for trading, will lead to interest payments on this capital. Purchasing the call option at $12 in a lot of 100 contracts will cost only $1,200. Yet the profit potential will remain the same as that with a long stock position. Effectively, the differential of $8,800 will result in savings of outgoing interest payment on this loaned amount. Alternatively, the saved capital of $8,800 can be kept in an interestbearing account and will result in interest income—a 5% interest will generate $440 in one year. Hence, an increase in interest rates will lead to either saving in outgoing interest on the loaned amount or an increase in the receipt of interest income on the saving account. Both will be positive for this call position + savings. Effectively, a call option’s price increases to reflect this benefit from increased interest rates.
 Interest Disadvantage in Put Option: Theoretically, shorting a stock with an aim to benefit from a price decline will bring in cash to the short seller. Buying a put has similar benefit from price declines, but comes at a cost as the put option premium is to be paid. This case has two different scenarios: cash received by shorting a stock can earn interest for the trader, while cash spent in buying puts is interest payable (assuming trader is borrowing money to buy puts). With an increase in interest rates, shorting stock becomes more profitable than buying puts, as the former generates income and the latter does the opposite. Hence, put option prices are impacted negatively by increasing interest rates.
The Rho Greek
Rho is a standard Greek (a computed quantitative parameter) that measures the impact of a change in interest rates on an option price. It indicates the amount by which the option price will change for every 1% change in interest rates. Assume that a call option is currently priced at $5 and has a rho value of 0.25. If the interest rates increase by 1%, then the call option price will increase by $0.25 (to $5.25) or by the amount of its rho value. Similarly, the put option price will decrease by the amount of its rho value.
Since interest rate changes don’t happen that frequently, and usually are in increments of 0.25%, rho is not considered a primary Greek in that it does not have as a major impact on option prices compared to other factors (or Greeks like delta, gamma, vega, or theta).
How a change in interest rates affects call and put option prices?
Taking the example of a Europeanstyle inthemoney (ITM) call option on an underlying trading at $100, with an exercise price of $100, one year to expiry, volatility of 25%, and an interest rate of 5%, the call price using BlackScholes model comes to $12.3092 and call rho value comes to 0.5035. The price of a put option with similar parameters comes to $7.4828 and put rho value is 0.4482 (Case 1).
When and How to Take Profits on Options
Buying undervalued options (or even buying at the right price) is an important requirement to profit from options trading. Equally important – or even more important – is to know when and how to book the profits. Extremely high volatility observed in option prices allows for significant profit opportunities, but missing the right opportunity to square off the profitable option position can lead from high unrealized profit potential to high losses. Many options traders end up on the losing side not because their entry is incorrect, but because they fail to exit at the right moment or they do not follow the right exit strategy.
Challenges With Options Trading
Due to the following four constraints, it becomes important to be familiar with and follow suitable profittaking strategies:
 Unlike stocks that can be held for an infinite period, options have an expiry. Trade duration is limited and once missed, an opportunity may not come back again during the short lifespan of the option.
 Longterm strategies like “averaging down” (i.e., repeated buying on dips) are not suitable for options due to its limited life.
 Margin requirements can severely impact trading capital requirements.
 Multiple factors for option price determination make it difficult to bank on a favorable price move. For example, the underlying stock moves favorably to enable high profits on an option position, but other factors, such as volatility, time decay, or dividend payment, may erode those gains in the shortterm.
This article discusses a few important methodologies for how and when to book profit in options trading.
Trailing Stop
A very popular profit taking strategy, equally applicable to option trading, is the trailing stop strategy wherein a predetermined percentage level (say 5%) is set for a specific target. For example, assume you buy 10 option contracts at $80 (totaling $800) with $100 as profit target and $70 as a stoploss. If the target of $100 is hit, the trailing target becomes $95 (5% lower). Suppose the uptrend continues with the price moving to $120, the new trailing stop becomes $114. A further uptrend to $150 changes the trailing stop to $142.5. Now, if the price turns around and starts going down from $150, the option can be sold off at $142.5.
Trailing stop loss allows you to benefit from continued protection against increasing gains and to close the trade once the direction changes.
Traders use it in multiple variants, depending upon their strategy and fitment.
 As price appreciates, the percentage level can be varied (initial 5% at $100 target can be changed to 4% or 6% at $120, per the trader’s strategy).
 The initial stoploss level can be set at same 5% level (instead of separately set $70).
 It can also be based on underlying price movements, instead of the option prices.
The key point is that the stop loss level should be set at neither too small (to avoid frequent triggers) nor too large (making it unachievable).
Partial Profit Booking at Targets
Experienced traders often follow a practice to book partial profits once a set target is reached, say squaring off a 30% or 50% position if the first set target ($100) is reached. It offers two benefits for options trading:
 Partial profit booking shields the trading capital to a good extent, preventing capital losses in case of a sudden price reversal, which is frequently observed in options trading. In the above example, the trader can sell five contracts (50%) when the set target of $100 is reached. It allows him to retain $500 capital (out of the initial capital of $800 to buy 10 contracts at $80).
 A rest open position allows the trader to reap the potential for future gains. A target hit of $120 offers a receipt of $600 ($120 * 5 contracts), bringing a total of $1,100. Another variant is to sell 50% or 60% of remaining, allowing room for further profit at the next level. Say three contracts are closed at $120 ($360 receipt) and the remaining two are closed at $150 ($300 receipt), the total sale value will be $1,160 ($500 + $360 + $300).
Partial Profit Booking for Buyers
Similar to the above scenario, partial profits are booked by traders at regular time intervals based on the remaining time to expiry, if the position is in profit. Options are decaying assets. A significant portion of an option premium consists of time decay value (with intrinsic value accounting for the rest). Most experienced option buyers keep a close eye on decaying time value and regularly square off positions as an option moves towards expiry to avoid further loss of time decay value while the position is in profit.
Buyers of an option position should be aware of time decay effects and should close the positions as a stoploss measure if entering the last month of expiry with no clarity on a big change in valuations. Time decay can erode a lot of money, even if the underlying price moves substantially.
Profit Booking Timing for Sellers
The time decay of options naturally erodes their valuation as time passes, with the last month to expiry seeing the fastest rate of erosion.
Option sellers benefit by getting higher premiums at the start due to high time decay value. But it comes at the cost of option buyers who pay that high premium at the start, which they continue to lose during the time they hold the position. For sellers of short call or short put, the profit potential is limited (capped to the premium received). Having predetermined profit levels (traders’ set level like 30%/50%/70%) is important to take profits, as margin money is at stake for option sellers. In the case of reversals, the limited profit potential can quickly turn into an unlimited loss, with the increasing requirements of additional margin money.
Profit Booking on Fundamentals
Option trading occurs not only on technical indicators. Many traders also take longterm positions based on fundamentals analysis, in order to benefit from a low trading capital requirement.
For example, assume you have a negative outlook about a stock leading to a long put position with two years to expiry and the target is achieved in nine months. Options traders can assess the fundamentals once again, and if they remain favorable to the existing position, the trade can be held onto (after discounting the time decay effect for long positions). If unfavorable factors (such as time decay or volatility) are showing adverse impacts, the profits should be booked (or losses should be cut).
Averaging Up
Averaging down is one of the worst strategies to follow in the case of losses in options trading. Even though it may be very appealing, it should be avoided. Instead, it is better to close the current option position at a loss and start fresh with a new one with a longer time to expiry. Remember, options have expiry dates. After that date, they are worthless. Averaging down may suit stocks that can be held forever, but not options. Instead, averaging up may be a good strategy to explore for profitmaking, provided there is sufficient time to expiry and a favorable outlook to the position continues.
For example, if the target of $100 is achieved, buy another five contracts in addition to those 10 bought earlier at $80. The average price is now ((10*80 + 5*100)/15 = $86.67). If the next target of $120 is hit, buy another three contracts, taking the average price to $92.22 for a total of 18 contracts. If the next target of $150 is hit, sell all 18 with a profit of (15092.22)*18 = $1040. Other variants include further buying (say three more at $150) and keeping a trailing loss (5% or $142.5).
The Bottom Line
Options trading is a highly volatile game. No wonder countries like China are taking their time to open up their options market. The highly volatile options market does provide enormous opportunity to profit, but attempting to do so without sufficient knowledge, clearly determined profit targets, and stoploss methodologies will lead to failures and losses. Traders should thoroughly test their strategies on historical data, and enter the options trading world with real money with predecided methods on stoplosses and profittaking.

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