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Options premium

The price paid to acquire the option. Also known simply as option price. Not to be confused with the strike price. Market price, volatility and time remaining are the primary forces determining the premium. There are two components to the options premium and they are intrinsic value and time value.

Intrinsic Value

The intrinsic value is determined by the difference between the current trading price and the strike price. Only in-the-money options have intrinsic value. Intrinsic value can be computed for in-the-money options by taking the difference between the strike price and the current trading price. Out-of-the-money options have no intrinsic value.

Time Value

An option's time value is dependent upon the length of time remaining to exercise the option, the moneyness of the option, as well as the volatility of the underlying security's market price.

The time value of an option decreases as its expiration date approaches and becomes worthless after that date. This phenomenon is known as time decay. As such, options are also wasting assets.

For in-the-money options, time value can be calculated by subtracting the intrinsic value from the option price. Time value decreases as the option goes deeper into the money. For out-of-the-money options, since there is zero intrinsic value, time value = option price.

Typically, higher volatility give rise to higher time value. In general, time value increases as the uncertainty of the option's value at expiry increases.

Effect of Dividends on Time Value

Time value of call options on high cash dividend stocks can get discounted while similarly, time value of put options can get inflated.

Next: Moneyness

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