Trader's Guide to Options Part 3
The information in this guide is intended to get you started with your understanding of options, the terminology, and their basic characteristics. In addition to this guide, it is recommended that you study all information available under the education section of your broker’s website. Most brokers who cater to options traders provide good information that will help you learn.
Intrinsic Value
In-the-money
At-the-money
Out-of-the-money
Time Value
Options have two parts that comprise their value; Intrinsic Value and Extrinsic Value. Extrinsic value is also known as time value. When an option is in-the-money (ITM) it has intrinsic value equal to the amount it is ITM. Option price - intrinsic value = time value.
Time value decays as expiration approaches. The closer to expiration, the faster time value decays. Sellers of options use time decay as part of their winning strategy. Time decay is a benefit for option sellers and a problem for option buyers.
The Reality of Trading
In the real world, investors very rarely exercise their option contracts to take profit from a trade. Instead, they simply BTC or STC the options prior to the expiration date. The advantage of doing so allows them to capture some of the time value of an option, in addition to the intrinsic value. It also allows them to use the leverage of options that do not require the larger amounts of capital required to actually buy and sell the underlying stock.
Let’s analyze some examples to become familiar with common terminology:
AAPL is trading at $360 and the following shows a BTO of 3 call contracts of the September $355 strike at an ask price of $27.40:
MA is trading at $294 and the following represents a STO of 2 put contracts of the July $290 strike at a bid price of $9.50:
Spreads
Call and Put options can be bought and sold in combinations that offer other investment strategies. Some of these include credit spreads, debit spreads, and combination options spreads, to name a few. For example, when opening a spread, one option will be STO and a different option will be BTO. Spreads can be an excellent way to mitigate risk.
This concludes the Trader's Guide to Options. Please let us know if you have any questions.
Intrinsic Value
In-the-money
- Call options are in-the-money if the stock price is above the strike price.
- Put options are in-the-money when the stock price is below the strike price.
- The amount by which an option is in-the-money is referred to as intrinsic value.
At-the-money
- Options are at-the-money when the stock price is trading at or very near the strike price.
Out-of-the-money
- Call options are out-of-the-money if the stock price is below the strike price.
- Put options are out-of-the-money when the stock price is above the strike price.
- If an option is out-of-the-money it has no intrinsic value.
Time Value
Options have two parts that comprise their value; Intrinsic Value and Extrinsic Value. Extrinsic value is also known as time value. When an option is in-the-money (ITM) it has intrinsic value equal to the amount it is ITM. Option price - intrinsic value = time value.
- XYZ stock is trading at 181.72
- The 180 call strike is 1.72 points ITM so, there is $1.72 of intrinsic value.
- $5.85 is the ask price. $1.72 of this is intrinsic value.
- $4.13 of the $5.85 ask price is time value.
Time value decays as expiration approaches. The closer to expiration, the faster time value decays. Sellers of options use time decay as part of their winning strategy. Time decay is a benefit for option sellers and a problem for option buyers.
The Reality of Trading
In the real world, investors very rarely exercise their option contracts to take profit from a trade. Instead, they simply BTC or STC the options prior to the expiration date. The advantage of doing so allows them to capture some of the time value of an option, in addition to the intrinsic value. It also allows them to use the leverage of options that do not require the larger amounts of capital required to actually buy and sell the underlying stock.
Let’s analyze some examples to become familiar with common terminology:
AAPL is trading at $360 and the following shows a BTO of 3 call contracts of the September $355 strike at an ask price of $27.40:- The underlying Apple stock value is $360 per share.
- The expiration date of the call is the third Friday in September.
- The strike price is $355.
- The call is in-the-money because the stock price is above the strike price.
- The premium is $27.40 per share.
- There is $5.00 of intrinsic value (in-the-money)
- There is $22.40 of time value (out-of-the-money).
- Number of shares represented is 300 (3 contracts x 100 shares per contract).
- Buyer is hoping the stock rises, increasing the intrinsic value and causing the value of the option to also increase.
- Since the expiration is about 3 months out, on a move higher the position is not subjected to rapid time value decay.
MA is trading at $294 and the following represents a STO of 2 put contracts of the July $290 strike at a bid price of $9.50:- The underlying Master Card stock value is $294 per share.
- The expiration date of the put is the third Friday of July.
- The strike price is $290.
- The Put is out-of-the-money because the stock price is above the strike price.
- The premium is $9.50 per share.
- Number of shares represented is 200 (2 contracts X 100 shares per contract).
- Seller is hoping that stock remains above $290 at expiration. This will result in time value decaying thus, reducing the price of the option. Since it was STO for $9.50, when time value decays, the seller will be able to BTC for less than $9.50 and lock in a profit.
Spreads
Call and Put options can be bought and sold in combinations that offer other investment strategies. Some of these include credit spreads, debit spreads, and combination options spreads, to name a few. For example, when opening a spread, one option will be STO and a different option will be BTO. Spreads can be an excellent way to mitigate risk.
This concludes the Trader's Guide to Options. Please let us know if you have any questions.
Disclaimer
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