Options Trading 103: Essential Stock Options Knowledge
Let’s Expand On Stock Options Basics…
Let’s continue with our ongoing series on stock options. As you know, option trading is the prime focus of my premium trading service, the Options Profit Pipeline.
In our last options basics article, we went into depth on the differences between calls and puts. I also explained the difference between in-the-money, out-of-the-money, and at-the-money options.
With these important concepts out of the way, let’s further our options knowledge with a discussion on intrinsic and time value. As you’ll see, understanding this important concept is a must for every options trader.
Let’s get to it…
Intrinsic vs. Time Value
Now that you know the difference between call and put options, let’s discuss how you buy one.
To purchase an option, you must pay a premium. Think of it as the upfront cost to add an option contract to your portfolio.
How is the premium determined?
There are two factors making up the premium you pay- intrinsic and time value.
First, let’s look at intrinsic value…
This is simply the difference between the underlying stock’s price and the strike price of the in-the-money option you’re trading.
In the case of a call option, the intrinsic value is determined by subtracting the strike price from the stock price.
Here’s an example…
Let’s say you’re buying an Exxon Mobil (XOM) April 2015, $95 call.
At the time of your option purchase, XOM stock is trading at $97 a share. The intrinsic value of the option is determined by subtracting $95 (the strike price) from $97 (the stock price). Of course, the result is $2.00 of intrinsic value.
Determining the intrinsic value of a put option is just the opposite…
To get the intrinsic value of an in-the-money put option, you subtract the underlying stock price from the strike price.
Let’s say you’re buying a Conoco Phillips (COP) April 2015, $64 put while the stock is trading at $62. In this case, the intrinsic value is determined by subtracting $62 from $64. Of course, the answer is $2.00 of intrinsic value.
Now, it’s important to realize that options only have intrinsic value if they’re trading in-the-money.
Out-of-the money calls and puts have zero ($0) intrinsic value (more on this in a second).
Now, this is where time value comes in…
Time Value Of Stock Options
What is time value?
It’s simply the option premium minus the intrinsic value.
Here’s how you calculate it…
Let’s assume the XOM April 2015, $95 call from above is selling for a premium of $3.30. We already know the intrinsic value of this option is $2.00 ($97 stock price – $95 strike price).
The time value in the option is the premium ($3.30) less the intrinsic value ($2.00). Of course, simple math tells you the time value is $1.30 ($3.30 – $2.00).
Now listen closely…
In the case of out-of-the money options, time value makes up 100% of the premium. There is no intrinsic value.
How can that be?
Remember, only in-the-money options have intrinsic value. If you’re purchasing out-of-the money call or put options, you’re simply purchasing time value.
And the most important thing to remember about time value is that it decays. That’s right, the time value of an option will eventually dwindle to zero ($0) at expiration.
It’s an important concept to grasp, so let me repeat it…
If an option is still out-of-the-money by expiration, it’s time value will decay to zero and the option will become worthless!
On the other hand, if an option is trading in-the-money at expiration, it will only be worth its intrinsic value- and nothing more.
Let’s Sum It All Up…
It’s essential you understand the concepts of intrinsic and time value when you’re trading options.
The two factors are vital in determining an option’s premium when you buy, and what it is ultimately worth at expiration.
If you’re still struggling with the concepts of time and intrinsic value, try visiting the Chicago Board Options Exchange’s education section.
That’s it for Option Trading 103. In coming articles, I’ll explain additional concepts including:
- Option Greeks: Delta, Gamma, Vega, and Theta
- Open Interest
- Option Spreads
- Option Trading Money Management Techniques
Until Next Time,
Justin Bennett
BIO: Justin Bennett is the head commodity research analyst at Commoditytradingresearch.com. With over a decade of real world trading experience, he finds ways for you to consistently profit from movements in commodities and the companies producing them. Sign up for our free reports and commodity newsletter at https://commoditytradingresearch.com/free-sign-up.
Category: Commodity Options Trading
