The Hindu Business Line : Using Futures/Options

Option premium is not highly sensitive to changes in interest rates. Given that the time of expiry of options is usually less than three months, even large changes in interest rates lead only to insignificant changes in premium.

The Rho of call option is always positive while that of put option is negative. It is the least significant among the option sensitivities. In general, the sensitivity of an option to interest rate is linked to the time remaining for expiration. Rho tends to decline to close to zero as time to expiration approaches.

Some of the characteristics of Rho are:

Options with longer time remaining to expiration are more sensitive to interest rates than options, which have shorter time for their expiration.

Options, which are deep out of the money, have low Rho while options that are at the money or deep in the money have a comparatively higher Rho.

Increase in interest rates will lead to increase in call option prices, while it will lead to a decline in put option prices.

Theta: Theta measures the sensitivity of option prices to the passage of time. As the time to expiry of an option approaches, the option premium will approach its intrinsic value. Intrinsic value is equal to the difference between the strike price of an option and price of the underlying stock.

Option premium is usually not equal to the intrinsic value of an option. There is one more component - referred to as the time value. Theta measures the sensitivity of this time value to the passage of time. Generally, theta is less than zero, that is negative, for both call and put options.

Consider the Tata Steel call option with a strike price of Rs 370 expiring on August 26. The option closed at a premium of Rs 32 on Friday. The underlying stock of Tata Steel closed at Rs 392. The difference between market price of the stock and the strike price, which works out to Rs 22, is the intrinsic value.

The difference between option premium and intrinsic value is the time value of an option. In this case, the time value works out to Rs 10.

The theta for this option is - 0.37. That is, with every passing day, the option premium will decline by Rs 0.37. Compounding this value of Rs 0.37 for a day at the interest rate of 4.5 per cent for 27 days, which is the time remaining to maturity, will work out to the time value of Rs 10.

Consider also the time value of the Tata Steel's call option with the same strike price expiring nearly two months later in October. The option premium is Rs 58.10. This means the time value of option is nearly Rs 36.10. The theta of this call option, however, is lower at nearly - 0.27. This is a result of the mathematics involved in calculation of the time value. This does not necessarily indicate that the October option is more attractive. This is true for all options. Shorter-term options have a higher theta than longer-term options. Theta will also be higher if the volatility of the underlying stock is higher. Higher volatility increases the probability of making more money. Therefore, time value of the option will be higher.

(Queries relating to futures/options may be sent to fno@thehindu.co.in or to Futures & Options, Kasturi & Sons, 859-860, Anna Salai, Chennai 600 002.)

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Max India: Accept

Textiles: Gloom is over for the looms

Quite warm enough to wrap around

`Insuring' more bang for the buck

The EPF rate crisis

Why pharma is good prescription

ING Vysya Select Stocks: Sell

Principal Resurgent India Equity Fund: Hold

HDFC Growth Fund

Top moves at Franklin Templeton

Fund Talk