Options ABC

Chapter 5: Option Premium

Now comes to the price of the option which is often called as option premium. It has two components:
Intrinsic Value

It is the difference between the market price/level of the underlying stock/index and the strike price/level of an option.

For call option, the difference is calculated by the market price/level of the underlying stock/index minus the strike price/level.

If the market price of the underlying stock is less than the strike price (Market Price < Strike Price), the option is out-of-the-money (OTM) and does not have intrinsic value.

If the market price of the underlying stock is equal to the strike price (Market Price = Strike Price), the option is at-the-money (ATM) and does not have intrinsic value.

If the market price of the underlying stock is greater than the strike price (Market Price > Strike Price), the option is in-the-money (ITM) and has intrinsic value.

It is the difference between the strike price/level of an option and the market price/level of the underlying stock/index.

For put option, the difference is calculated by the strike price/level minus market price/level of the underlying stock/index.

If the strike price is greater than the market price of the underlying stock (Strike Price > Market Price), the option is in-the-money (ITM) and has intrinsic value.

If the strike price is equal to the market price of the underlying stock (Strike Price = Market Price), the option is at-the-money (ATM) and does not have intrinsic value.

If the strike price is less than the market price of the underlying stock (Strike Price < Market Price), the option is out-of-the-money (OTM) and does not have intrinsic value.

It is the difference between the market price/level of the underlying stock/index and the strike price/level of an option.

  Call Options Put Options
Market Price/Level of Stock/Index < Strike Price

Intrinsic Value = 0

Moneyness = Out-of-the-money

Intrinsic Value is positive

Moneyness = In-the-money

Market Price/Level of Stock/Index = Strike Price

Intrinsic Value = 0

Moneyness = At-the-money

Intrinsic Value = 0

Moneyness = At-the-money

Market Price/Level of Stock/Index > Strike Price

Intrinsic Value is positive

Moneyness = In-the-money

Intrinsic Value = 0

Moneyness = Out-of-the-money

Time Value

It is the extra amount which the option buyer is willing to pay for the probability that the option may become deeper in-the-money due to favourable movement in the underlying stock price/index level for the remaining life-span of the option. Time value is affected by two elements:

1) time to expiry, and

2) volatility of the underlying stock/index.

1) Time to Expiry

An option contains more time value as the time to expiry is longer, holding other factors constant. This is because the longer the remaininig time until expiry, the greater the probability that the option can go in-the-money, and therefore the more the option is worth.

Time value reduces as time goes by, this is called "Time decay". Time decay is NOT favourable to options HOLDERS and is favourable to options WRITERS. This is a very important concept in options trading.

Time decay is not constant. It accelerates when the option approaches expiry.

2) Volatility of the underlying stock/index

Volatility can be defined as the degree to which the price of a stock or the level of an index tends to fluctuate over a specified period of time.

Increases in volatility increases the magnitude of upward or downward movements of the underlying stock/index, and hence the probability of becoming in-the-money for calls and puts. Volatility is embedded in the Time Value of an option. Therefore higher volatility results in higher time value and thus, the premium.

There are two types of volatility, historical volatility and implied volatility.

Historical Volatility refers to the range of price/level movements that have been seen in a particular stock/index over a specified period of time in the past.

Implied Volatility is deduced from market traded option price.

As market participants have different views about future market movement, the levels of volatility used in their option pricing model vary and therefore will arrive at different prices.

Options investors input the market price of an option to an
option pricing modelOption price is complex to value. It depends on a number of different factors including underlying price, strike price, time to expiry, volatility, dividend and interest rate. There are many pricing models in use. Amongst the most common models are Black-Scholes model and Binomial Options Pricing Model. so as to estimate the level of volatility used by the person who quotes the price. It is referred to as Implied Volatility.

Options investors can then compare the implied volatility of a given market price with their own expectations about the volatility of the underlying shares or with the implied volatilities of other comparable derivative products to decide on the strategies to be used.

Factors affecting stock option premium

There are six factors which affects the value of option premium. The effects of the factors are summarized below. Please note that the remaining factors are assumed to be constant when reading the effect of moving the value of a single factor.

Factor Change in Factor Change in Call Premium Change in Put Premium
Underlying Price
Strike Price
Time to Expiry*
Volatility
Dividend
Interest Rate

*Not necessarily true for deep in-the-money or deep out-of-the-money options

Please access Options/Warrants Calculator under Options Tools section to try out the effect of different factors on option premium.