Chapter 5: Option Premium
Now comes to the price of the option which is often called as option premium. It has two components:
Intrinsic Value
It is the difference between the market price/level of the underlying stock/index and the strike price/level of an option.
For call option, the difference is calculated by the market price/level of the underlying stock/index minus the strike price/level.
If the market price of the underlying stock is less than the strike price (Market Price < Strike Price), the option is out-of-the-money (OTM) and does not have intrinsic value.
If the market price of the underlying stock is equal to the strike price (Market Price = Strike Price), the option is at-the-money (ATM) and does not have intrinsic value.
If the market price of the underlying stock is greater than the strike price (Market Price > Strike Price), the option is in-the-money (ITM) and has intrinsic value.
It is the difference between the strike price/level of an option and the market price/level of the underlying stock/index.
For put option, the difference is calculated by the strike price/level minus market price/level of the underlying stock/index.
If the strike price is greater than the market price of the underlying stock (Strike Price > Market Price), the option is in-the-money (ITM) and has intrinsic value.
If the strike price is equal to the market price of the underlying stock (Strike Price = Market Price), the option is at-the-money (ATM) and does not have intrinsic value.
If the strike price is less than the market price of the underlying stock (Strike Price < Market Price), the option is out-of-the-money (OTM) and does not have intrinsic value.
It is the difference between the market price/level of the underlying stock/index and the strike price/level of an option.
| |
Call Options |
Put Options |
| Market Price/Level of Stock/Index < Strike Price |
Intrinsic Value = 0
Moneyness = Out-of-the-money |
Intrinsic Value is positive
Moneyness = In-the-money |
| Market Price/Level of Stock/Index = Strike Price |
Intrinsic Value = 0
Moneyness = At-the-money |
Intrinsic Value = 0
Moneyness = At-the-money |
| Market Price/Level of Stock/Index > Strike Price |
Intrinsic Value is positive
Moneyness = In-the-money |
Intrinsic Value = 0
Moneyness = Out-of-the-money |
Time Value
It is the extra amount which the option buyer is willing to pay for the probability that the option may become deeper in-the-money due to favourable movement in the underlying stock price/index level for the remaining life-span of the option. Time value is affected by two elements:
1) time to expiry, and
2) volatility of the underlying stock/index.
1) Time to Expiry
An option contains more time value as the time to expiry is longer, holding other factors constant. This is because the longer the remaininig time until expiry, the greater the probability that the option can go in-the-money, and therefore the more the option is worth.
Time value reduces as time goes by, this is called "Time decay". Time decay is NOT favourable to options HOLDERS and is favourable to options WRITERS. This is a very important concept in options trading.
Time decay is not constant. It accelerates when the option approaches expiry.
2) Volatility of the underlying stock/index
Volatility can be defined as the degree to which the price of a stock or the level of an index tends to fluctuate over a specified period of time.
Increases in volatility increases the magnitude of upward or downward movements of the underlying stock/index, and hence the probability of becoming in-the-money for calls and puts. Volatility is embedded in the Time Value of an option. Therefore higher volatility results in higher time value and thus, the premium.
There are two types of volatility, historical volatility and implied volatility.
Historical Volatility refers to the range of price/level movements that have been seen in a particular stock/index over a specified period of time in the past.
Implied Volatility is deduced from market traded option price.
