Strike Price in Options

[dinu]

Hi All

It might be a very stupid question and too basic. Forgive me for that.

I would like to know how one estimates the strike price in an option since it determines the intrinsic value which is then tied to the greeks.

Is it estimated based on the underlying asset price only and if then how?

Regards

Abraham

 

[David Harper CFA FRM]

Hi Abraham,

I will try and answer but only on the condition you never apologize for stupid questions. We have learned so much from an inquiry into the basics (if only the experts would ask stupid questions, we could avoid some trouble, eh?)

The strike price (K or X), like the observed asset price (S) and term to maturity (T) does not need to be estimated. (On the other hand, volatility must be estimated, as does *expected* dividend yield and risk-free interest rate. Though we could probably argue the interest rate as objectively true or estimated. I found rf rate, in practice, to be unobjective).

Jorion Ch 1 distinguishes between security (e.g., stock) and derivative (e.g., stock option). In an equity stock option, the option is the derivative instrument that references the underlying stock. The derivative instrument has its own existence, so its strike price is a function of a contractual (i.e., agreed upon btwn counterparties) definition. If you and I enter into an over the counter (OTC) option on Microsoft's stock, we define contractually what is the strike price (it is not a property of MSFT's stock); similarly, if you look at exchange-traded listings of stock options, for any given stock (underlying secruity) , there can be multiple stock options (derivative instruments that reference the underyling) each with different contractually defined strike prices. So, strikes prices are defined by the contract, agreed upon by the counterparties.

Hope that helps, David

 

[sudeepdoon]

Hey David and Abraham,

I would like to add a few words that I know on the topic.

So for the exchange traded options, when ever these are floated into the market (which is some exchanges in the first working day); there correspond to many different strike price. Taking the example of NSE i.e National Stock Exchange, India. we have here a 5-1-5 options strike price. which means that for ever underlying stock there are options with 11 different strike price such that 5 are in the money, 5 are out of the money and 1 is at the money.

Each exchange has a offset for strike price. Taking example of a stock whose current price.i.e when the options are introduced in the market is Rs 100 and the offset is Rs 2. Then the market would have options with the following strike prices: Rs 100 (At the money), Rs 98, Rs 96, Rs 94, Rs 92, Rs 90 and Rs 102, Rs 104, Rs 106, Rs108.

I hope this would be helpful...

David: Is there no way by which I can have monitor on all forums and activities on the members page through RSS reader... I have subscribed to one, but I miss some cool activity somewhere... Thanks

 

[David Harper CFA FRM]

Sudeep,

Thank you, great information on NSE!

Re: RSS, yes of course, I would like that too. I know our CMS has such functionality, I have just added it to our developer's (growing) to do list. Shouldn't take too long...

Thanks, David

 

[dinu]

Hi David

This is fantastic. I have read too much into derivatives and find myself at embarassing situations when I get stumbled upon by a basic question. I think I can go ahead with my studies in full force with the backdrop that your forum is there to give me an helping hand.

Sudeep: Thanks for the wonderfull empirical illustration. Much Appreciated!

Thanks and Regards,

 

[dinu]

Hi David,

One more basic question. How do you think the exchange fits the offset and if I want to estimate the volatility of an option , how Do I do it, apart from estimation of the greeks.

Regards

Dinu

 

[scorpiomanoj]

Hi Dinu,

I think volatility is a variable in option pricing formulas showing the extent to which the return of the underlying asset will fluctuate between now and the option's expiration. Volatility arises from daily trading activities and is expressed as a percentage coefficient within option pricing formulas like Black Sholes. How volatility is measured will affect the value of the coefficient used.

I think the Black-Scholes pricing of options can be taken as equal to the option's minimum value plus additional value for the option's volatility: The greater the volatility, the greater the additional value. N(d1) and N(d2) are the two vol factors.
Option's minimum value = S - Ke^(-rt) , where, S is the Stock Price and K is the Strike Price
Options min value plus vol factors = S x N( d1)- Ke^(-rt) x N(d2) (Black Sholes method)
N(d1) and N(d2) are cumulative probabilty distribution functions of d1 and d2 respectively.
d1=(ln (s/k) + (r+0.5 sigma ^2 ))/sigma sqrt t
d2= d1-sigma sqrt t
Hence, given S,K,t,r and the options value, volatility (i.e. sigma) can be derived.

 

[Visual Chefs]

Hi Sundeep

I believe the RSS feed url are looking for is:

Main feed for forum
http://forum.bionicturtle.com/rss/

There is also a RSS feed for each individual forum on the site.

Example: The feed for the Quantitative Analysis (10% F, 20% L1) forum is:
http://forum.bionicturtle.com/rss/5/

The RSS icon at the bottom of each page is dynamic depending on what forum you are in. I will look into adding a general forum feed link to the forums so that you can subscribe to all from anywhere.

Sincerely,
Shawn

 

[David Harper CFA FRM]

Shawn,

Thanks re the RSS information, I did not understand this.
Re: "I will look into adding a general forum feed link to the forums so that you can subscribe to all from anywhere."
This would be fabulous, would love one RSS feed for all forum feeds. Thanks, David H