Option Buying: How to Calculate Option Premiums

This is a practical guide based on my experience and this strategy works for me 8/10 times.

Typically, when you buy options at the BEGINING of the expiry, you need to ensure that the PREMIUM + OTM sum does not exceed 6%-7% of the current market price.

Let’s take an example of Larsen and Toubro:

Price at the BEGINING of the expiry = 1,520. Let us assume you are bullish on the stock.

Let’s assume premiums are as under:

ATM 1520CE – Rs 75
OTM 1560 – Rs 45
OTM 1580 – Rs 35

Let’s check which of these CEs makes for the best buy:

1. ATM 1520CE: LT’s current price is 1520 and the ATM option premium is Rs 75, which works out to 4.9% (75/1520 X 100).

2. OTM 1560CE: LT’s current price is 1520 and the OTM portion is Rs 40 (1560-1520) + option premium is Rs 45 = RS 85, which works out to 5.6% (85/1520 X 100).

3. OTM 1580CE: LT’s current price is 1520 and the OTM portion is Rs 60 (1580-1520) + option premium is Rs 35 = RS 95, which works out to 6.3% (95/1520 X 100).

So, if you are an options buyer, you can choose option (1) or (2) from the above. Though option (3) is not very expensive, I would stay away because it crosses my lower threshold of 6%.

If you are extremely bullish on LT and figure it will go to 1700-1800 in that month, then you should go for a HERO or ZERO trade. In such a trade you can choose to buy a really far away OTM CE of 1640+ by paying a small price that you are willing to forgo.

In this form of extreme trading, the OTM + premium calculation does not come into play.

I have witnessed many buyers pay premiums as high as 8%-10% and then crib about options being lousy derivative instruments. Well, it’s the trader who’s at fault because he’s overpaying.

THETA (PASSAGE OF TIME) and PREMIUMS

Now, as time decays, so will the premiums. By the 15th of the month, the 6% criteria should be read as 3-4%, and so on. Example: By the 10th of that month the premium that you pay per option should be about 4%, and the premium that you pay on the 25th of the month should not be more than 1.5%-2% (Let’s face it, it won’t drop below these levels except on the expiry day).

CONCLUSION

You can try this strategy on both CE and PE. However, know that identification of a stock (strong or weak) is supremely important. Don’t go by your feelings, make a strong screener to pick stocks before buying options.

If you have any questions, feel free to post with real examples. I’ll answer when I get the time. Good luck.