Options value depends on tangible and intangible factors. There is typically an active secondary market in options before their expiration date.
Options holders seek to sell to make a profit or limit a loss, and options writers want to buy to offset their positions.
For example, someone who had sold a call on a particular stock option at a particular exercise price might want to buy a call on the same stock option with the same expiration date and at the same exercise price if an exercise seems likely.
That offsetting purchase takes the investor out of the marketplace, eliminating the obligation to make good on an exercise.
How to understand option pricing?
Investors should have a solid understanding of the variables affecting an option’s value before entering the world of options trading. The price of a stock today, its intrinsic value, its time to expiration or time value, volatility, interest rates, and any cash dividends paid are a few examples.
Options contracts expire after a fixed period; hence the amount of time left has a monetary value tied to it. This value is known as the time value. As expiration nears, you have to monitor your positions closely to determine whether an option has moved in-the-money or out-of-the-money and what action you should take.
Otherwise, you risk missing an opportunity to realize a profit or limit a loss. A buy-and-hold strategy that might be advantageous for stock investing works differently than options investing. Options are wasting assets, meaning they have no value after expiration.
An option’s premium has two parts: an intrinsic value and a time value. Intrinsic value is the amount by which the option is in-the-money. Time value is the difference between whatever the intrinsic value is and what the premium is. The longer the amount of time for market conditions to work to your benefit, the greater the time value. The premium of a call option changes as a result of volatility, which has an impact on the estimated return. Both intrinsic prices and volatility are factors that influence option prices. Option premiums are affected by volatility: high volatility increases them, whereas low volatility decreases them.
What is the difference between in-the-money, at-the-money, and out-of-the-money?
The strike price of an option and the likelihood it will be exercised is closely tied to the current market price of the underlying instrument. The relationship between them is so central to how options trade that it’s described in a special vocabulary. An at-the-money option means that the market and strike prices are the same.
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An in-the-money option means the market price is higher than a call option’s strike price and lower than a put option’s strike price. With an out-of-the-money option, the opposite is true. The market price is lower than a call’s strike price and higher than a put’s. That makes it unlikely that the option will be exercised, especially if it’s due to expire shortly.
What is the intrinsic value of the option?
An option’s intrinsic value is what it would be worth at any given moment if you exercised it. For example, if you hold a call on stock XYZ with a strike of $25, and XYZ is currently trading at $30, your call is in-the-money by $5, and therefore its intrinsic value is $5 per share, or $500 for the 100-share contract. If the stock were trading at $20, on the other hand, the option would have an intrinsic value of $0 since it is out-of-the-money.
Even if a call has a $5 intrinsic value because it’s in-the-money by $5, the premium isn’t necessarily $500 since the cost of an option also takes into account its time value or the potential that the option will continue to make gains before expiration. If the premium for your XYZ call is $700, or $7 per share, that means the time value that traders give your option is $2 per share. By the same token, an option with an intrinsic value of $0 might also be trading for $2 a share, its time value.
There’s no fixed value for a given amount of time before expiration — it depends on how investors value the particular option. As expiration nears, the time value of most options decreases since the potential for price changes falls. Near expiration, most options trade at or around their intrinsic value.
LEAPS
While standard options all expire within a year, it’s possible to trade equity options that expire up to three years in the future. Those options are called Long-Term Equity Anticipation Securities, or LEAPS. They trade just as regular options do.
The listing exchange chooses the securities on which to offer LEAPS, based in large part on investor interest. They make up about 17% of all options.
What things must you know about options value?
Every options contract is defined by its terms, which are standardized and set by the options exchange where the option is listed. An options class is the entire group of calls or puts available on a given underlying instrument. An options series includes only those options in a class that have the same expiration month and strike price, which are the only terms within a class that vary.
So all calls for stock XYZ would be in the same class, but the XYZ calls that expire in April — April XYZ calls — with a strike price of 50 would be considered a series.
Contract size. The size of the option contract is how much of the underlying product will change hands if the option is exercised. For most equity options, the contract size is 100 shares.
Expiration month. Every option expires in a given month, set in the contract terms. You can buy an option expiring from one month to three years. Options that expire in a given month typically expire on the third Friday of the month. However, brokerage firms may allow transactions on the Friday of expiration or set an earlier cut-off.
Strike price. The strike price is the amount per share the seller will receive, and the buyer will pay for the shares that change hands, regardless of the market price for those shares at exercise.
Delivery. There are two kinds of delivery. Physical-delivery options mean the actual underlying instrument changes hands. Cash-settled options require cash to be paid in fulfillment of the contract. The amount of cash depends on the difference between the strike price and the value of the underlying instrument. It is also determined using a formula defined in the contract.
Expiration style. American-style options may be exercised at any point before expiration. European-style options can be exercised only at expiration, not before.
Options Trading For Beginners [Full Guide] by Inna Rosputnia
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