Making smart trades requires some basic understanding of how options are priced and the factors that influence the price. Now I am not talking about learning how to perform the necessary calculus and determining the price of options based upon the Nobel Prize winning Black-Scholes formula. I am talking about understanding the basic relative relationships that form the components of the formula and being able to know what will happen to the price of an option as a variable changes.
Options Investing Basics
But first, let’s cover a few basic definitions that need to be understood when discussing the price of options. The price of an option, or premium, is comprised of two parts: the intrinsic value and the extrinsic (or time) value. The intrinsic value is that portion of the premium that represents actual stock market value if the option were exercised and the stock sold in the open market at the same moment in time.
Options Trading: Intrinsic Value
Let’s say you owned a call option with a strike price of $20 while stock ABC is trading at $25 per share. The $20 strike call option could be exercised and the stock would be purchased at $20 per share. Shares could then be sold in the open market at $25. The intrinsic value is $5 per share. A $15 call option would have an intrinsic value of $10 per share.
In contrast, a $20 put option has no intrinsic value since it makes no sense to purchase the stock at $25 and sell it at $20 in order to lose money. Instead, it is the $30 put option that has $5 in intrinsic value. It is important to understand this difference and be able to reason through the implications of having an option contract exercised in order to determine the intrinsic value.
Options Trading: Time Value
The remainder of the option premium that is not represented by the intrinsic value is the time value. If the $20 strike call option for stock ABC which is trading at $25 has one month until expiration and trades for $6 per share, the intrinsic value is $5 per share and the time value is $1 per share. The time value adds to the intrinsic value because the stock still has the potential to appreciate over the next month.
Even a $20 put option on a stock trading at $25 with one month until expiration has some value. The intrinsic value is zero but the time value is worth $1 per share. The time value decreases as an option gets closer to expiration. It is vitally important to be able to determine the time value of an option contract since trading options is essentially buying and selling time.
In future posts, we will discuss those factors that influence the time value of the option premium since intrinsic value will increase or decrease solely with the movement of the underlying stock.
This is a guest post from the Options Dude. The Options Dude has more than a decade of experience both buying and selling options. He blogs at Options Dude and enjoys sharing his options trading experiences with readers.
Hi Optionsdude, Nice simple explanation for advanced investors. Hope you will get into the conservative strategy of selling covered calls.
Hello, Barb. I would love to write about selling covered calls.
This is a great overview post on options. Also, as Barbara mentioned, covered call strategies are pretty conservative and the nice thing about them is that as the seller of the call, you get to take advantage of the time permium before the option expires.