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There was a sharp spurt in the option prices of Tata Steel though only two or three days were left for the expiry on 30 December.

1) Why this sudden surge in the option prices?

2) Is it due to high-implied volatility of the stock?

3) The prices computed by option calculator were substantially lower why?

4) Even the out-of-the-money 380 Call America had appreciated about 85 per cent though the expiration was just two days away.

Would you please explain why is it so? — M. Vijay

Consider prices of the call options of Tata Steel at the end of December 24.

Excepting the options with the strike price of Rs 360 and Rs 370, the time value was insignificant.

The time value is the excess of option premium over and above the difference between spot price and strike price.

For instance, in the case of the call option with a strike price of Rs 320, the time value was only 80 paise. The spot price was Rs 358.9 and the option premium was Rs 39.7.

The time value was low as the time to expiration was only a few days and participants in the market thought the probability of Tata Steel surging in value substantially in the few remaining days were low.

As the time value was low, the delta of all these options was quite high.

The option premium consequently rose almost as much as the option premium.

The surge in option premium can thus be attributed to the high delta and the sharp rise in spot price of Tata Steel.

The option premium had to rise because they needed to be at least equal to their intrinsic value.

Intrinsic value is the difference between the strike and spot price.

The implied volatility of the options did not have anything to do with the surge in prices.

As the time to expiration approaches, the implied volatility of a deep-in-the-money option will keep rising.

The high implied volatilities of the deep-in-the-money call options were simply due to this principle.

If the implied volatilities had been lower then the gain in option premium would have been even higher.

Consider the call options with the strike prices of Rs 350, Rs 360 and Rs 370.

All these three options had implied volatilities of less than 50 per cent on December 24.

These three options also ended up with substantial appreciation in the option premium in the week that just ended.

We can conclude that an out-of-the-money option with low-time value will deliver relatively large returns if spot price appreciates sharply.

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.

Suresh Krishnamurthy

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