InvestorQ : What are the factors that go into the calculation of the fair value of an option? # What are the factors that go into the calculation of the fair value of an option? Answer 3 years ago
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Broadly, there are 5 factors that impact the calculation of the fair valuation of an option…

Firstly, there is the market price of the underlying stock. In case of call options, higher market prices increase the value of the options. The reverse is true in case of put options.

Secondly, there is the Strike price of the option. In case of a call option, a higher strike price reduces the fair value of the option. In case of a put option, the reverse is true.

Thirdly, there is the Volatility of the stock price. Higher volatility higher is the value of the option. That is because if the volatility is in your favour then the option is more valuable and if the volatility is against you then you just lose the premium. Higher volatility is positive for call options and for put options.

Fourthly, there is the Time to expiry of the option. Greater the time to expiry, more the probability of you making money on the option. Longer time to expiry is positive for call options and also for put options.

Fifthly, there is the Risk free interest in the market. Why are interest rates relevant? Options strikes pertain to a future date and hence time value becomes material. Higher interest rates mean lower present value of the strike price and therefore higher option value in case of call options. The reverse is true in case of put options.

These 5 variables are the key inputs that are used to calculate the fair value of the option and then to decide whether the option is underpriced or overpriced. Now let us tweak this formula a little bit. Instead of finding the fair value of option, we assume the option price is the fair value of the option. We then use the other inputs and then calculate the missing volatility figure. This is called implied volatility (IV) as it is the volatility that is implied in the option market price. When the IVs of a series of Nifty strikes of puts and calls are combined the outcome is the VIX index. Since the VIX captures the volatility assumption in various strikes, it becomes a good and reliable gauge of the extent of risk perception in the market.

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