Value and Prices in Options Trading–Part II

July 27, 2009 by  
Filed under Options Trading

If you have read Part I of this series, you will remember the example of a stock whose market price was $27 with a June 30 call option and premium of $2. This option was sold at a discounted premium because it was out of the money, but this lower price is traded for a much higher risk. Because the possible profits are diminished as the expiration date nears, risks are inherently higher, too.

This phenomena of premiums reducing as the expiration date nears is known as ‘decay’ in option trading. Many investors are successful in these trades because they are knowledgeable about calculating their proposed risks.

As seen in Part I, options in the money have intrinsic value, and the moreso that this is true, the more the price movement will likely mimic that of the market price. For example, assume the market price of the same option rises to $35 and the premium is now $3: $35 – ($30 + $3) = $2, and IV = $35 – $30 = $5.

Even though this doesn’t seem to be much of a gain, remember these will be multiplied by 100 (standard options are sold in lots of 100). So, $2 x 100 = $200 in profit.

These examples are all assuming an ‘American’ option that can be exercised at any time before the expiration date. ‘European’ options are always exercised on the date of expiration.

Remember that the investors selling these options don’t want to just part with their money – they’re in the business of making money, too. This type of scenario would likely be subject to arbitrage, or buying and selling in different markets to make quick profits due to these differences in price. Arbitrage has the effect of forcing prices to a point where investors will only break even.

This is why time value is such an important calculation when speculating. Using the difference between strike and market prices and the time left before the expiration date, the profitability of an option is estimated.

If you’re considering two different options, they likely have different strike prices; if they still mature on the same date, their time values will differ. Also, options may have identical strike prices, but different expiration dates – this also accounts for different time values. Premiums are always affected by the amount of these different values, too.

As an example, we can assume the market price stays the same, and the two different options’ strike prices are identical. Obviously, it must be the expiration date that’s different, and a chart showing the premium versus amount of time to maturity will be declining. These charts are often found in online options trading sites.

It’s also important to realize that options with out of the money strike prices will be priced at lower premiums as the date of expiration nears. This is due to the declining time value.

Always remember that the closer an option comes to expiration, its premium price will lower, but your risk also becomes higher. Using these basic concepts of value and price will help you with your online options trading practice, but more options trading education is needed to form your own trading strategies.