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Understanding
Price
By
now you should have a good idea of the versatility of options. We know what an option is and how it works, and we even
know the basic strategies but as you may have guessed we have
barely scratched the surface. In this lesson we will learn what factors determine option
prices and the language you will want to know to use more advanced
strategies effectively.
This
stuff won't "bake your noodle" but it may bring it to
the simmering point so we are going to start very slowly.
As
we know the option price is called the premium. There are two components of premium, Intrinsic Value and Time
Value. Both of these
aspects are very important so let's take a moment to delve deeper.
Intrinsic Value
Intrinsic
value is the cornerstone of option pricing and it is also the
most basic factor. Quite simply, an option's intrinsic value is the amount an
option is in-the-money.
To
determine the intrinsic value of a call option simply subtract the
strike price from the current price of the underlying security. For put options the opposite is true,
simply subtract the
current price of the underling security from the strike price. Consider these examples.
Apple
Computer common stock is trading at $90 per share and David owns
the Apple Computer November 85 calls. The intrinsic value of this contract is $5 per share
(current price of Apple Computer ($90) less the strike price of
the option ($85)).
Apple
Computer common stock is still trading at $90 per share and Mike
owns the Apple Computer November 105 puts. The intrinsic value of this contract is $15 (strike price
of the option ($105) less the current stock price of Apple
Computer ($90)).
When
an option is at-the-money or out-of-the money the intrinsic value
is always zero.
Time or Extrinsic Value
You
are probably thinking, wait just a minute, there are lots of
options that still have premiums yet they have no intrinsic value,
what gives?
Time
value, often called extrinsic value reflects the amount of money
investors are willing to pay above and beyond intrinsic value. In most cases investors are willing to pay this additional
money because they are betting that the option will move into the
money at or before expiration. In effect, investors buying options with no intrinsic value
are paying for time.
To
determine time value simply subtract the intrinsic value from the
current price of option contract. Consider this example.
Yahoo
common stock is trading at $180. Greg thinks Yahoo! is ready to rise and buys one Yahoo
November 175 call for a premium of $13. Greg needs to be right about the timing of the anticipated
rally because he is paying a hefty time value of $8 (cost of the
Yahoo November 175 call ($13) less the intrinsic value of $5). The intrinsic value calculation is the current price of
Yahoo ($180) less the strike price of the option ($175).
Time
value diminishes at an exponential rate as an option nears its
respective expiration date. This process, called time decay, accelerates exponentially
until the time premium declines to zero at expiration. All options have no time value at expiration, any remaining
premium will consist entirely of intrinsic value.
standardization
factors effecting premium
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