Value and Prices in Options Trading–Part I

July 25, 2009 by  
Filed under Options Trading

Perhaps the biggest difference between trading stocks and options is the fact that options have an expiration date that any action must be exercised by, or lose your entire investment. Conversely, those who buy stock always have the option to hold and wait for an upturn in the market.

This expiration makes it much more important to determine an option’s value accurately, but several tools have been developed to do this for you. The most common methods for determining the value of an option include calculating intrinsic and time values.

Intrinsic value simply shows you by how much an option strike price is in the money. Always remember that the strike price is that at which the asset is bought or sold if you choose to exercise your option. ‘In the money’ means that this set price is lower or higher than the market price, depending upon whether you’re discussing a put or call option.

Call options trading can calculate the intrinsic value with the following formula:

IV = market price – strike price

Because options are purchased before the expiration date, the value of these options changes as the expiration date approaches. This change, over time, reduces the value of the option as an investment option.

For call options, one with only a few days left before the expiration date is usually calculated to have less value when compared to one that is three months away. When the expiration date is reached, the option is either in the money (profitable), or out of the money (loss is realized). ‘Time value’ is the amount that an option’s price is over and above the intrinsic value.

For example, formulas to determine intrinsic and time values of a put option are as follows:

IV = strike price – market price; TV = premium – IV

‘At the money’ options mean that the market price is equal to the strike price. ‘Out of the money’ options mean that the strike price is higher in a call and lower in a put than the market price. Either of these scenarios means that the option has no current intrinsic value, but only time value (because the IV can change with time as the market price changes).

As an example, let’s assume the market price of a stock is currently $27, and has a June 30 call. This ’30′ is not a date, but rather the strike price of an option. This option would be considered out of the money if the premium was $2, because $27 – ($30 + $2) = -$5.

With no value in this option, this doesn’t necessarily mean you wouldn’t invest in it. If the time period is still a few months out, there is still potential for profit if you believe the market price will change. This allows you to minimize risk of losing huge amounts of money by hedging your investment dollars.

This is where your talents as a speculative investor come in to play. Use several online options trading tools that can automatically calculate and track the changing intrinsic and time values of a particular option, giving you the options trading education needed to make a valid trade.

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