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B. Venkatesh

THE terms, "option value" and "option price", though interchangeably used in the newspapers and investment magazines, are different.

Option price is the price at which the option trades in the market. If Satyam 240 calls trade at Rs 4, you can say that the calls are priced at Rs 4 (typically, referred to as four points).

Option value, on the other hand, is a function of the option valuation model.

If you input the stock price, strike price, interest rate, days-to-maturity, and volatility into an option valuation model, you will get the option value. Suppose this value is six, you can say that the Satyam 240 calls are valued at Rs 6 (or six points).

Option value and option price are important because we should always look for options that are trading at lower than their theoretical value; that is, options whose prices are lower than their values.

Such options are said to be trading cheap; if option prices are higher than their values, such options are said to be trading rich.

But you should not buy options just because they are trading cheap. Why? The option value depends on the volatility that you input into the option-valuation model. Higher volatility translates into higher option values, and lower volatility, into lower values.

Now, there is a possibility that your option value was higher than the option price because your volatility input was higher. To provide for the error in forecasting volatility, you should choose options where the implied volatility (the volatility number that you get when you input the option price into the model) is considerably lower than your forecast volatility. Why?

Suppose your forecast volatility is 39 per cent, and the implied volatility is 30 per cent. The higher difference provides you a higher margin of forecasting error of 9 percentage points before the options ceases to remain cheap.

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