| Skip to a different lesson... I II III IV V VI VII |
In
this final installment of our options series we'll cover two very important
topics--intrinsic and time value. These two concepts are what comprise an option�s
price. By being familiar with these terms and knowing how to use them, you'll
find yourself in a much better position to choose the option contract that best
suits your particular investment needs.
Intrinsic Value -- This is the value that any given option would have if it were exercised today. It is defined as the difference between the option's strike price (X) and the stock's actual current price (CP). In the case of a call option, you can calculate this intrinsic value by taking CP - X. If the result is greater than zero (in other words, if the stock's current price is greater than the option's strike price), then the amount left over after subtracting CP - X is the option's intrinsic value. If the strike price is greater than the current stock price, then the intrinsic value of the option is zero--it would not be worth anything if it were to be exercised today (please note that an option's intrinsic value can never be below zero). To determine the intrinsic value of a put option, simply reverse the calculation to X � CP.
To illustrate, let's say IBM stock is priced at $105. In this case, an IBM 100 call option would have an intrinsic value of $5 ($105 - $100 = $5). However, an IBM 100 put option would have an intrinsic value of zero ($100 - $105 = -$5 ---> since this figure is less than zero, the intrinsic value is zero. Again, intrinsic value can never be negative.). On the other hand, if we were to look at an IBM put option with a strike price of 120, then this particular option would have an intrinsic of $15 ($120 - $105 = $15).
Time Value -- This is the second component of an option�s price. It is defined as any value of an option other than its intrinsic value. Looking at the example above, if IBM is trading at $105 and the IBM 100 call option is trading at $7, then we would say that this option has $2 of time value ($7 option price - $5 intrinsic value = $2 time value). Options that have zero intrinsic value are comprised entirely of time value. Time value is basically the risk premium that the seller requires to provide the option buyer with the right to buy/sell the stock up to the expiration date. Think of this component as the �insurance premium� of the option.
Time value is easy to see when looking at the price of an option, but the actual derivation of time value is based on a fairly complex equation. Basically, an option's time value is largely determined by the amount of volatility that the market believes the stock will exhibit before expiration. If the market does not expect the stock to move much, then the option's time value will be relatively low. Meanwhile, the opposite is true for stocks that are expected to be very volatile. For example, if IBM stock is priced at $100 and the IBM 100 call is priced at $5, then the market is expecting at least a 5% ($5 / $100) upside move prior to expiration. High-beta stocks, or those that tend to be more volatile than the general market, usually have very high time values because of the uncertainty of the stock price prior to an option's expiration.
Conceptually, this all makes perfect sense. After all, if you are an options seller, then you will probably be willing to sell options at very low prices on shares of, let's say, a slow-moving utility stock like Southern Company (SO). On the other hand, if you were to sell options on shares of a highly volatile stock like Amazon.com (AMZN), then you would require much greater compensation. After all, Amazon's stock has a much greater chance of moving quickly in one direction or the other, which could end up costing you a great deal of money if the stock moves in a favorable direction for the option buyer.
Another important thing to understand about time value is that it decreases as an option gets closer and closer to expiration. Why is this the case? Well, the easiest way to think about this is that as the option approaches expiration, the underlying stock has less and less time to move in a favorable direction for the option buyer. For example, assuming that both options were trading at the same price, would you rather purchase an IBM 110 call option that expires this month or one that expires next year? From a buyer's perspective, you would obviously rather purchase the one that expires next year. After all, the chances of IBM moving above $110 within the next year are likely to be far greater than the chances of it soaring that high within the next month.
In the real world, of course, these two call options would not likely trade at the same price. Because the option that expires next year has a better chance of moving higher, its time value will be significantly greater. In this regard, options are priced somewhat like insurance; the longer the time horizon, the more expensive they will be.
One other key item to note is that the further "in-the-money" (please see lesson #2 if you are unfamiliar with this term) an option is, the less time value it will have. Options that are deep "in-the-money" generally trade at or near their actual intrinsic value. This is because options with a significant amount of intrinsic value built in have a very low chance of expiring worthless. Therefore, the primary value they provide is already priced into the option in the form of their intrinsic value.
When using options in future, we hope you will consider each option's intrinsic and time values to help you determine which contracts to choose. In general, remember that options that are further "in-the-money" are less likely to expire worthless and therefore have less risk of loss. On the other hand, they are much more expensive to purchase. Options that are out-of-the-money have a high risk of expiring worthless, but they tend to be relatively inexpensive. As the time value approaches zero at expiration, "out-of-the-money" options have a greater potential for total loss if the underlying stock moves in an adverse direction.
Conclusion
In this seven-part options series we have covered the basic concepts that you
need to know in order to start using options effectively. The following
summarizes what you have learned so far (to review any of our previous options
lessons, please visit the links below):
Lesson I : Options Characteristics
-- Introduces the basic concepts of how options work.
Lesson II : Factors that Effect Option Prices --
Describes the various factors that determine an option's price, including the
underlying stock price, the option's strike price, volatility, the risk-free
rate, and the amount of time to expiration. This lesson also introduces put and
call trades.
Lesson III : Selling Options -- Outlines the risks and
rewards associated with being on the seller�s side of an option contract.
Lesson IV : Portfolio Hedging -- Describes how to use options to hedge an entire portfolio of stocks.
Lesson V : Spreads and Combinations -- Introduces you to several advanced options trading strategies that involve the use of two or more option positions.
Lesson VI : Collars and Butterflies -- Describes two additional trading strategies that use multiple options positions.
Lesson VII : Intrinsic Value vs.
Time Value -- Brings you a closer look at the two key components of every
option's price.
As a final note, we would like to emphasize that options contain unique risks
and may potentially result in significant loss of capital. Because they allow
investors to control large blocks of stock with relatively little capital,
options can create tremendous amounts of financial leverage. Savvy investors use
this leverage to aid in their hedging and speculating activities. However,
it can also be abused. Thousands of overly aggressive investors have been
completely wiped out using options. While this is very uncommon, you should
always be aware that options present the potential for significant losses as
well as gains.
To invest safely, a good rule of thumb is to never invest more in an option than you could afford to lose on a common stock. For instance, in our recurring IBM example, if an investor believes that IBM is a good investment and has $10,000 to invest in the shares, then he/she would be foolish to buy $10,000 worth of call options. A better strategy for the investor would be to determine the maximum amount of loss he/she is comfortable with, then use that amount to purchase options. In this case, if 10%, or $1,000, is the maximum loss that the investor feels would be acceptable, then he/she should only purchase this amount in options. By using this technique, you'll ensure that you don't take excessive risks in the options market.
Once again, we hope that you do choose to use options in your portfolio and take advantage of all the benefits that they offer. Options provide a wonderful means to not only profit from share price movements, but also to hedge your portfolio positions and manage your risk. The best part is that you do not need to work for a Wall Street hedge fund to master the basic techniques--you can easily learn how to use options profitably on your own. I sincerely hope that this seven-part series has helped you along on that path.
Thank you for reviewing my options trading lessons. Please make sure to check back often in the coming weeks, as I will provide a number of options trading examples to help you continue with the learning process (available exclusively on our web site at www.StreetAuthority.com).
Good options trading!
-- Jeff Bishop
Staff Writer
StreetAuthority.com
|
|
