When you buy shares in a company, there are a number of factors you might consider. For example, you might look at its fundamentals — things like the balance sheet, gearing, profit and loss, earnings per share and dividend yield.
You might then take a broader look at the industry it operates in and the health of the economy in general. If you like to use price charts, you might also check to see if the stock price looks to be in an uptrend.
Whichever method you choose, you’ll arrive at a value or price level that you think the shares are worth. As with any market, buyers and sellers are matched as per their own view of this value.
But how do you value an option?
There are two basic components that combine to give you the value of an option. One is called intrinsic value, and the other is time value. You’ll quite often see the following formula in most of the material you read about options:
Option price = Intrinsic value + Time value
Let’s now have a look at these two components. First, intrinsic value. This refers to the amount by which an option is ‘in-the-money’ (ITM). Don’t let this bit of jargon throw you though, let’s run through a quick example to show you what it means.
Let’s say that AMP [ASX:AMP] is trading at $5.90 per share. If you buy a call option with a strike price of $5.50, this option has an intrinsic value of 40 cents per share. Meaning that if you exercised your call option, you would be buying your AMP shares ($5.50 strike price) at 40 cents below the current market price ($5.90).
If instead you buy an AMP call option with a strike price of $6.50 per share (using the same example with AMP trading at $5.90), then the call option is ‘out-of-the-money’ (OTM). That is, it doesn’t have any intrinsic value. There wouldn’t be any point exercising your call option because you could buy the shares cheaper on the market.
There are a couple of simple rules to remember when it comes to intrinsic value which should make it easier to understand.
Call option — if the strike price is below the market price, a call option is ‘in-the-money’ (ITM). That is, it has intrinsic value. If the strike price is above the market price, then the call option is ‘out-of-the-money’ (OTM). That is, it doesn’t have any intrinsic value.
A simple way to calculate if a call option has intrinsic value is by the following formula:
Intrinsic value = share price – option strike price
Put option — if the strike price is higher than the share price, a put option is ‘in-the-money’ (ITM). That is, it has intrinsic value. If the strike price is below the market price, then the put option is ‘out-of-the-money’ (OTM). That is, it doesn’t have any intrinsic value.
A simple way to calculate if a put option has intrinsic value is by the following formula:
Intrinsic value = option strike price – share price
There’s also a third type — an ‘at-the-money’ option (ATM). As you will no doubt have already worked out, this is where the share price is trading at the same level as the strike price of the option. An ATM option doesn’t have any intrinsic value.
In summary, intrinsic value represents how much you’d gain if you exercised the option right now. If the share price is $5 and a call option is $4.50, then you would gain 50 cents by exercising the option at the current price.
The second component of an option price is its time value.
Time value represents that part of the option price (premium) beyond its intrinsic value. If an option is trading at 50 cents and has 30 cents of intrinsic value, then the time value is 20 cents. If an option has no intrinsic value, such as an ATM option, then all of the option price is time value.
So for example, if an option is trading at 50 cents with no intrinsic value, then the total value of the option is all time value. In this example, that’s 50 cents.
It’s important to think of option prices in terms of these two basic components. That is, intrinsic value and time value.
Intrinsic value is the real or ‘tangible’ value that you know is embedded in the option price. Time value essentially represents the amount the option buyer is prepared to pay above the intrinsic value for their trade to have the best chance of success before expiry.
As an option buyer, the longer time you have to be ‘right’, the more you will be prepared to pay for your option. And from the option writer’s side, the longer the time frame in which they could be exercised, the more premium they will want to receive.
You know that options have an expiry date and that the value of an unexercised option at expiry is zero. So whatever the buyer pays for the option, it only has value for a limited time. Each day that passes without the option being exercised reduces the time value of the option.
In other words, as the clock ticks down, there is less opportunity for the option buyer to be ‘right’. As such, the less they’ll be prepared to pay for the option each passing day.
This continual decline in the time value of the option is called ‘time decay’. You’ll sometimes see it referred to as the Greek word ‘theta’. The important thing to remember from an option buyer’s perspective is that this time decay is slowly but surely working its way against the value of your option.
From an option writer’s perspective, time decay works in their favour. The option they sell decays each day until expiry. Of course, in writing an option, they take on an obligation for receiving this premium.
These are the basic components that make up the value of an option. However, you’re probably already thinking that there must be more to it than that. How about the price of the underlying share and its volatility? Or the volatility of the market in general.
And what about the impact of dividends and corporate actions? Things like rights issues and interest rates. Next week, in Part II I’ll be back to show you how these all impact the value of an option.
Editor, Options Trader