Option Characteristics
The first thing you need to know is that options have a value. Just like with a stock price, there are numerous characteristics that make up an options price.
The three main drivers being:
The underlying stock price
Time until expiration &
Volatility
When we were talking about buying calls, this is how that premium you're paying is determined.
What you need to know is, just like a stock price, options can be mispriced too! This is important! If you were planning to buy a stock, it would be extremely important to first understand it's value. It's the same when it comes to buying (or selling) an option contract. First understand how the option is being priced (if it's over or under valued),once you know the value, it's much easier to decide what kind of option trade you want to use.
If you can understand where the cost of the option is most heavily placed, you'll be able to better decide if the option price is acceptable to you.
Can an option really be mispriced?
Now that's a question for the record books, and an incredibly important one to ask.
Short answer you say? Fine…
YES!
Absolutely options can be mispriced.
Just like stocks, the price of options can go a little crazy from time to time. Don't get me wrong, stock option prices are rational most of the time….But, because of this, we can take advantage of those times when it goes a little silly.
We'll get into the specifics of that another time. For now, I want to discuss the basics of how options are priced.
There are only two types of value:
Options prices are split into two separate categories of value:
Intrinsic value &
Extrinsic value
Today we're going to focus on the first, Intrinsic Value because I think it's the easiest to
understand and therefore a great starting point for us.
Intrinsic value
The intrinsic value is the amount the option would be worth if you exercised it today.
Let me show you an example…
Example #1
Our old pal Frank has bought a call option contract for XYZ company (his obvious favourite).
The stock is now trading at $45
The call option has a $43 strike and a current premium of $2.50.
The option expires a month from now.
Frank wonders what the intrinsic value of this call is? He also wonders if it's in the money (ITM), at the money (ATM), or out of the money (OTM)?
QQQ (Quick Quiz Question)
What do you think the intrinsic value of Frank’s call is?
Is Frank’s call:
ITM
ATM, or
OTM
Hint: remember, the intrinsic value is what the call would be worth to Frank if he exercised it today… if you don't remember how to do that, check back here:
call options; what you need to know. Buying
So, what do you think? Do you have the answer?
I'm going to answer #2 first…
QQQ Answer #2: Frank’s call is… ITM (in the money). Remember that for a call option to be in the money the stock price has to be higher than the strike price, because the stock is higher in this example, we know that Frank’s call is in the money.
This correlates well with question #1
For Frank's call to have any intrinsic value at all, the option must be In the money (ITM). Since Frank’s call is ITM we know that there must be at least some intrinsic value.
QQQ Answer #1: Frank’s option has… $2.00 of intrinsic value.
Calculating Intrinsic value is very simple. Simply subtract the call strike price from the stock price.
In Frank's case:
Call option strike of $43
Stock Currently trading at $45
Intrinsic value = $45 - $43 = $2.00
Not bad, right?
So how did you do on those questions? Get one right?
Don't worry if you didn't, I'll go over a few more before we're through, so you'll have plenty of time to let this sink in.
More examples to practice with
I'm going to put the answers below just so you have time to think about the answers before I give them away.
Example #2
Frank buys a call option on XYZ with a strike of $63.
The XYZ stock is currently trading at $67.
The option expires in 6 months.
For this one, Frank is super lazy and doesn't check to see what the option premium is worth right now. That being said…
QQQ #1 Is the option:
ITM
ATM
OTM
QQQ #2 what is the intrinsic value of this option?
Example #3
Frank decides to buy yet another Call Option On XYZ.
Strike price = $25
Stock price = $25
The option expires in 2 months.
Current option premium of $1.25
QQQ #3 Is the option:
ITM
ATM
OTM
QQQ #4 What's the options intrinsic value?
Example #4
Frank owns a call option on XYZ Company
The strike is $36
The stock price is $33
It expires 1 year from today
Current option premium is $4.00
QQQ #5 is the option:
ITM
ATM
OTM
QQQ #6 What is the options intrinsic value?
Let's do one more, I think you're getting the hang of it.
Example #5
Frank buys a Call on XYZ company (surprise, surprise)
Strike is $125
Stock is at $135
Premium is at $12.50
Expires in 2 months
QQQ #7 is the option:
ITM
ATM
OTM
QQQ #7 What is the intrinsic value?
QQQ #8 What is the extrinsic value?
Answer Time
Though I am almost certain you came up with the correct answers, let's go over them here just as review.
Example #2
Bought a Call option on XYZ
Strike price is $63
Stock is trading at $67
Expires in 6 months
Premium isn't known
QQQ #1 Answer: The option is currently ITM
QQQ #2 Answer: The option has $4.00 of intrinsic value ($67 - $63 = $4.00).
Note: To find our intrinsic value we don't need to know the total amount of premium for an option, all we need is the strike price, and the stock price.
Example #3
Bought a Call option on XYZ
Strike price is $25
Stock is trading at $25
Expires in 2 months
Premium is currently $1.25
QQQ #3 Answer: The option is currently ATM
QQQ #4 Answer: The options has Zero intrinsic value ($25-$25 = $0.00 )
Note: Even though the option is worth $1.25, none of it is intrinsic value. Remember that the intrinsic value is what the option would be worth today if we were to exercise it.
So in this example we could exercise our right to buy the stock at $25, then turn around and sell it again at $25, netting us a big fat $0.
One trick to remember is that an option has to be at least slightly ITM for there to be any Intrinsic value. Once we know it's not, we know we have zero intrinsic value.
Example #4
Bought a Call option on XYZ
The strike is $36
The stock price is $33
It expires 1 year from today
Current option premium is $4.00
QQQ #5 Answer: The Option is Currently OTM
QQQ #6 Answer: This option has zero intrinsic value.
Again, this option is out of the money because the strike price is higher than the stock price, and you would not make any money if you were to exercise it today. Since we know that the option has to be ITM, we know it has no intrinsic value.
Example #5
Frank buys a Call on XYZ company
Strike is $125
Stock is at $135
Premium is at $12.50
Expires in 2 months
QQQ #6 Answer: The option is currently ITM (Yay)
QQQ #7 Answer: The option has $10.00 of intrinsic value ($135 - $125 = $10.00)
QQQ #8 Answer: The option has $2.50 of extrinsic value ($12.50 - $10.00 = $2.50)
So I threw in a bit of a new question on that last one…
Did you manage to figure it out?
If you did, well done. You remembered that an option premium is composed entirely of Intrinsic and Extrinsic value.
Once we know the intrinsic value, the extrinsic value is whatever is left over.
So, as you may be able to see, the intrinsic value of an option is entirely dependent on the underlying stock price.
Without a move in the underlying stock price, intrinsic value will stay the same.
Bonus Tip
If the option is not ITM, and therefore has no intrinsic value, the option premium is made up entirely of Extrinsic value.
Summary
Today we learned:
The value of an option changes depending on the underlying stock price, the time until expiration, and the volatility. These three factors working together can lead to mispricing of options, and therefore, we can learn to take advantage of that.
Option premium is entirely made up of Intrinsic and Extrinsic value. As a result of this, once we know one half of the equation, we know the other.
How to calculate the intrinsic value, and by default the extrinsic value.
We (us and Frank), went through a bunch of different examples on how to calculate intrinsic value, and you basically Aced all of them. Pretty sweet.
There you go. You're one big step closer to understanding the value that makes up an option contracts cost. Great work today.
Thanks for reading,
We'll talk soon.
~Ryan Chudyk~
P.S.
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