📘 Module 2: Option Valuation & The Greeks
🎯 Learning Objectives
- Differentiate intrinsic vs. extrinsic (time) value
- Understand key pricing drivers: price, time, volatility, rates, dividends
- Interpret the core Greeks: Delta, Gamma, Theta, Vega, Rho
- Use IV/IVR to judge when options are rich or cheap
- Apply basic put–call parity logic
1) Option Value = Intrinsic + Extrinsic
- Intrinsic value (calls): max(0, Spot − Strike)
- Intrinsic value (puts): max(0, Strike − Spot)
- Extrinsic value: premium − intrinsic (driven by time & expected volatility)
- Moneyness: ITM has intrinsic, ATM ~ zero intrinsic, OTM = zero intrinsic
2) Pricing Drivers (Intuition)
- Underlying price: moves intrinsic.
- Time to expiry: more time ⇒ more extrinsic (all else equal).
- Volatility (expected): higher IV ⇒ higher premium.
- Interest rates: modest effect; calls tend to benefit as carry increases.
- Dividends: reduce call value and increase put value (expected drop on ex-div).
3) A Quick Word on Models
Models like Black-Scholes relate price, time, volatility, rates, and dividends to a fair option value. Traders don’t need the full math to use the outputs (Greeks) for risk and decision-making.
4) The Core Greeks (Trader’s Lens)
- Delta (∂Price/∂Spot): Expected option price change for ₹1 move in underlying; also ~probability of finishing ITM (rough guide).
- Gamma (∂Delta/∂Spot): How fast Delta changes; highest near ATM, surges near expiry.
- Theta (∂Price/∂Time): Time decay per day; negative for buyers, positive for sellers.
- Vega (∂Price/∂Vol): Sensitivity to IV; longer-dated/ATM options have larger Vega.
- Rho (∂Price/∂Rates): Sensitivity to interest rates; usually smaller impact than Vega/Theta.
5) Implied vs. Historical Volatility
- Implied Volatility (IV): market’s forward expectation embedded in prices.
- Historical Volatility (HV): realized past movement.
- IV Rank (IVR): where current IV sits vs. its 1-year range (0–100%). Higher IVR ⇒ premium relatively “rich”.
6) Liquidity Considerations
- Prefer tight bid–ask spreads, good volume/open interest.
- Wide spreads add friction and slippage to entries/exits.
7) Put–Call Parity (No-Arb Intuition)
Call − Put ≈ Spot − PV(Strike) − PV(Dividends).
If this relation is far off, arbitrageurs step in; for us, it’s a logic check on relative pricing.
🧮 Mini Examples
- Example A: Spot ₹120; Call 115 priced ₹9 ⇒ Intrinsic ₹5, Extrinsic ₹4.
- Example B: Spot ₹1,950; Put 2,000 priced ₹70 ⇒ Intrinsic ₹50, Extrinsic ₹20.
✅ 15 Objective Questions (with Answers)
- Intrinsic value of a 18,000 Call when NIFTY is 18,120 is:
a) ₹0 b) ₹120 c) ₹−120 d) ₹18,120
Answer: b - Extrinsic value equals:
a) Premium + Intrinsic b) Premium − Intrinsic c) Strike − Spot d) Spot − Strike
Answer: b - Which Greek measures sensitivity to the underlying’s price?
a) Vega b) Theta c) Delta d) Rho
Answer: c - Gamma is typically highest for options that are:
a) Deep ITM b) OTM far from expiry c) ATM near expiry d) LEAPS deep OTM
Answer: c - Theta for a long option position is usually:
a) Positive b) Negative c) Zero d) Equal to Vega
Answer: b - All else equal, increasing implied volatility will most directly:
a) Decrease extrinsic value b) Increase extrinsic value c) Reduce intrinsic value d) Increase strike
Answer: b - Vega is generally larger for options that are:
a) Near-dated and deep OTM b) Longer-dated and ATM c) Near-dated and deep ITM d) Extremely short-dated ITM
Answer: b - Which statement is most accurate?
a) IV is backward-looking; HV is forward-looking
b) IV and HV are identical measures
c) IV is forward-looking; HV is backward-looking
d) Neither relates to pricing
Answer: c - High IV Rank (IVR ≥ 50) typically suggests:
a) Options relatively cheap b) Options relatively rich c) No effect on premium d) Intrinsic rises
Answer: b - Put–call parity mainly helps traders to:
a) Maximize Theta b) Check relative pricing consistency c) Predict dividends d) Eliminate Gamma risk
Answer: b - A 100 Put with premium ₹7, Spot ₹96 has extrinsic value of:
a) ₹0 b) ₹3 c) ₹7 d) ₹4
Answer: d - As expiry approaches (all else equal), which is most true?
a) Theta accelerates b) Theta slows c) Vega increases d) Gamma decreases
Answer: a - Which factor usually has the largest day-to-day impact on option prices?
a) Rho b) Vega c) Delta moves from Spot d) Dividend yield
Answer: c - All else equal, an increase in interest rates tends to:
a) Increase call values slightly b) Reduce call values c) Increase put values d) Have no theoretical effect
Answer: a - A very wide bid–ask spread primarily hurts traders by:
a) Raising IVR b) Increasing slippage/transaction cost c) Reducing Theta d) Increasing intrinsic
Answer: b
🧾 Key Takeaways
- Price, time, and volatility shape extrinsic value; intrinsic is purely moneyness.
- Delta/Theta/Vega are your daily P&L drivers; Gamma tells you how fast Delta will change.
- Use IV and IVR to decide when to prefer buying vs. selling premium.
- Liquidity (tight spreads) is part of edge; avoid illiquid strikes when possible.
Previous Module ➜ Options Basics
Next Module ➜ Directional & Neutral Strategies (Spreads)
