The value of options is influenced by both tangible and intangible factors. Generally, there is an active secondary market for options before they expire.
Options holders typically aim to sell their options to realize a profit or limit a loss. Conversely, options writers may look to buy options to offset or close out their positions.
For instance, if an investor has sold a call option on a specific stock at a particular strike price, they might choose to buy a call option on the same stock with the same strike price and expiration date if it seems likely that the option will be exercised.
This offsetting purchase effectively closes out the original position and removes the obligation to deliver the underlying stock if the option is exercised.
How to understand option pricing?
Investors should thoroughly understand the factors that influence an option’s value before engaging in options trading. Key variables include the current stock price, the option’s intrinsic value, time to expiration (time value), volatility, interest rates, and any cash dividends paid.
Options contracts have a fixed expiration period, and the time remaining before expiration has a monetary value known as the time value. As the expiration date approaches, it’s crucial to monitor your positions closely to assess whether an option has moved in-the-money or out-of-the-money and decide on the appropriate action.
Failing to monitor your options closely can result in missing out on opportunities to realize profits or limit losses. Unlike a buy-and-hold strategy that works well for stocks, options are considered wasting assets, meaning they lose value and become worthless after expiration.
An option’s premium consists of two components: intrinsic value and time value. Intrinsic value is the amount by which the option is in-the-money, while time value is the difference between the option’s premium and its intrinsic value. The longer the time until expiration, the greater the time value, as there is more potential for favorable market conditions.
Volatility also plays a significant role in determining an option’s premium. High volatility tends to increase the premium, as it raises the potential for the option to move in-the-money. Conversely, low volatility decreases the premium. Both intrinsic value and volatility are critical factors influencing option prices.
What is the difference between in-the-money, at-the-money, and out-of-the-money?
The strike price of an option and its likelihood of being exercised are closely linked to the current market price of the underlying instrument. This relationship is fundamental to options trading and is described using specific terminology. For instance, an option is considered “at-the-money” when the market price of the underlying asset is equal to the option’s strike price.
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An “in-the-money” option means the market price of the underlying asset is higher than the strike price for a call option or lower than the strike price for a put option. Conversely, an “out-of-the-money” option occurs when the market price is lower than the strike price for a call option or higher than the strike price for a put option. This makes it unlikely that the option will be exercised, particularly if it is approaching its expiration date.
What is the intrinsic value of the option?
An option’s intrinsic value represents what it would be worth if exercised immediately. For example, if you hold a call option on stock XYZ with a strike price of $25 and XYZ is currently trading at $30, your call option is in-the-money by $5. Therefore, its intrinsic value is $5 per share, or $500 for a 100-share contract. If XYZ were trading at $20, the option would be out-of-the-money and have an intrinsic value of $0.
However, even if a call option has an intrinsic value of $5, the total premium is not necessarily $500. The premium also includes time value, which accounts for the possibility that the option could gain further value before expiration. For instance, if the premium for your XYZ call is $700, or $7 per share, this means the time value is $2 per share (i.e., $7 premium minus $5 intrinsic value). Conversely, an option with an intrinsic value of $0 might still be trading at $2 per share, reflecting its time value.
The time value of an option is not fixed and varies based on investor perceptions of the option’s potential. As expiration approaches, the time value generally decreases because the potential for further price movements diminishes. Consequently, near expiration, most options trade close to their intrinsic value.
LEAPS
Standard options typically expire within a year, but you can also trade equity options with expiration dates extending up to three years into the future. These are known as Long-Term Equity Anticipation Securities (LEAPS). LEAPS function similarly to regular options.
Exchanges select the securities eligible for LEAPS based largely on investor demand. LEAPS constitute approximately 17% of all options traded.
What things must you know about options value?
Each options contract is defined by its standardized terms, which are established by the options exchange where the option is listed. An options class encompasses all calls or puts available for a specific underlying instrument. Within a class, an options series refers to those options with the same expiration month and strike price—these are the only terms within a class that vary.
For example, all calls for stock XYZ would be part of the same class. However, the XYZ calls that expire in April with a strike price of $50 would constitute a specific series.
The contract size indicates the amount of the underlying asset that will be exchanged if the option is exercised. For most equity options, this contract size is 100 shares.
Expiration Month: Each option is set to expire in a specific month, which is defined in the contract terms. Options can have expiration dates ranging from one month to up to three years in the future. Typically, options expire on the third Friday of the expiration month, though some brokerage firms might allow transactions until the Friday of expiration or set an earlier cutoff.
Strike Price: The strike price is the price per share at which the option’s buyer can purchase (or the seller will sell) the underlying asset, irrespective of the market price at the time of exercise.
Delivery: There are two types of delivery for options:
- Physical Delivery: The actual underlying asset is exchanged between the buyer and seller.
- Cash Settlement: Instead of delivering the underlying asset, cash is exchanged based on the difference between the strike price and the market value of the underlying asset, as defined by a formula in the contract.
Expiration Style:
- American-Style Options: These can be exercised at any time before the expiration date.
- European-Style Options: These can only be exercised at the expiration date and not before.
Options Trading For Beginners [Full Guide] by Inna Rosputnia
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