📘 Module 2: Option Valuation & The Greeks (Based on George Fontanills' Book)

 

📘 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.

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🧮 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)

1. Intrinsic value of a 18,000 Call when NIFTY is 18,120 is:
   a) ₹0   b) ₹120   c) ₹−120   d) ₹18,120
   Answer: b
2. Extrinsic value equals:
   a) Premium + Intrinsic   b) Premium − Intrinsic   c) Strike − Spot   d) Spot − Strike
   Answer: b
3. Which Greek measures sensitivity to the underlying’s price?
   a) Vega   b) Theta   c) Delta   d) Rho
   Answer: c
4. 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
5. Theta for a long option position is usually:
   a) Positive   b) Negative   c) Zero   d) Equal to Vega
   Answer: b
6. 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
7. 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
8. 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
9. 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
10. Put–call parity mainly helps traders to:
    a) Maximize Theta   b) Check relative pricing consistency   c) Predict dividends   d) Eliminate Gamma risk
    Answer: b
11. A 100 Put with premium ₹7, Spot ₹96 has extrinsic value of:
    a) ₹0   b) ₹3   c) ₹7   d) ₹4
    Answer: d
12. As expiry approaches (all else equal), which is most true?
    a) Theta accelerates   b) Theta slows   c) Vega increases   d) Gamma decreases
    Answer: a
13. 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
14. 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
15. 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.

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