Pricing Characteristic of Options

Option premiums are based upon intrinsic value and time value, where

premium = intrinsic value + time value.

For Example:

Shares in ABC are trading at $254 and your broker tells you that the ABC Apr 240 call option is trading at $24. How is this $24 calculated and what does it represent?

Intrinsic value

Intrinsic value is the amount by which the underlying share price differs from the option's exercise price. Using the above example of ABC call options, therefore, the premium of $24 is made up of $14 intrinsic value (underlying share price of $254 - call exercise price of $240) with the remaining $10 being time value. Where an option has intrinsic value it is said to be in-the-money. Calls are in-the-money when the underlying share price is higher than their exercise price. Puts are in-the-money when their exercise price is higher than the underlying share price.

Options which have no intrinsic value, i.e., calls whose exercise price is higher than the underlying share price or puts whose exercise price is lower than the underlying share price, are said to be out-of-the money and their premium is made up entirely of time value. Options whose exercise price is the same as or close to the underlying share price are said to be at-the-money. The premium of such options will largely be time value, but may contain intrinsic value depending on the current price level of the underlying shares.

It should be noted that intrinsic value is always either positive or 0. Out-of-the money options will not have a negative intrinsic value.

Time value

Time value is primarily affected by the time remaining to expiry of the option contract. The longer an option has until expiry, the greater its time value will be. This added value can be seen as the price paid by the option holder for continuing exposure to movements in the price of the underlying shares. It is the value in addition to the intrinsic value which the market places on that option and as such also includes factors such as current interest rates, dividend yields and volatility.

As expiry approaches, the time value of an option will decrease until it reaches 0 at expiry. This erosion of time value is known as time decay. The rate of time decay is non-linear and accelerates as expiry approaches.

Risk

Like all investments, options are not without risk. The buying of options involves a limited risk. That is to say that the maximum loss is limited to the price paid for the option and therefore is known at the outset. However, the writing (selling) of options is a potentially high-risk strategy requiring a high degree of product knowledge. Investors should not write options until they have a thorough understanding of the implications.

If you are not a seasoned investor, and are still learning the ins and out of trading equities, you should definitely put trading options aside for another day.