|Course 502: Introduction to Options|
|Understanding Option Pricing|
Two key phrases from our definitions for a call and put are "option to buy" and "option to sell." The owner of a call or put is not obligated to take any action. Thus, a call or put never has a value less than $0 before it expires. Consider the following example:
You own a call that gives you the right to buy a stock for $50. However, at expiration, the stock is priced at $45. Why would you exercise your right to purchase the stock for $50 when you can buy it for less in the stock market? You wouldn't. So, your call is worth $0 anytime the stock finishes below your strike price, which is $50 in this example.
When talking about option prices, people often refer to intrinsic value and premium to intrinsic value. (This intrinsic value has nothing to do with the intrinsic value we refer to when talking about the discounted cash flow of a company.) An option's intrinsic value is the difference between its strike price and the underlying stock price, when it favors the owner of the option. People often refer to intrinsic value as the amount that the option is "in the money." Let's look at three examples, assuming we are in 2012:
1. FEB13 60c when the stock is trading at $75
In this case, you own a call option that allows you to purchase the stock for $60 when it is trading for $75. We would say this call option has an intrinsic value of $15 because it gives you the right to purchase the stock for $15 less than you could purchase it for in the stock market.
2. OCT14 80p when the stock is trading at $50
In this case, you own a put option that allows you to sell the stock for $80 when it is trading for $50. We would say this put option has an intrinsic value of $30 because it gives you the right to sell the stock for $30 more than you could sell it for in the stock market.
3. JUL13 50c when the stock is trading for $40
In this case, you own a call option that allows you to buy the stock for $50 when it is trading for $40. This option has no intrinsic value. It is considered "out of the money."
Let's take a closer look at the third example above. Although it has no intrinsic value, we discover that the option is trading for about $2 in the marketplace. Why is that? Although the option isn't in the money now, there is still some time left (before expiration) for the stock to move such that it could place the option in the money. This is referred to as time value or option value.
In the case of the second example, the option may be trading for $32 even though the intrinsic value is only $30. In this case the option is trading at a $2 premium to its intrinsic value. This premium is also known as the time value.
Next: Drivers of Option Value >>
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