In the previous section, we found out that some options have an “immediate
value” or “immediate benefit” at the time they are purchased while others do
not. It’s time now to introduce some more terminology that will help you understand why.
We discovered that an option’s price must reflect any immediate value in
holding it. For instance, we found that the July $35 call could give a trader an
immediate benefit of $2.11 since the stock is trading for $37.11. If the stock is
trading for $37.11 and you have a call that gives you the right to buy the stock for
$35, you’re better off with the call by $37.11 - $35 = $2.11. hat $2.11 worth of
immediate benefit must be reflected in the price, and we see that it is since that
call is priced higher at $2.70. In option lingo, we’d say that the $35 call has $2.11
worth of intrinsic value. It will really help if you learn to substitute the words
“immediate benefit” or “immediate value” for intrinsic value. If the stock is trading
for $37.11, we know the $35 call must be worth at least $2.11 in the open market.
In other words, options must be worth at least their intrinsic value.
If there is any value in the option over and above this amount, it is called time
value or time premium. (Some texts will also refer to this as extrinsic value.) he
time value is due to the fact that there is still time remaining on the option. Since
the July $35 call was trading for $2.70 and the intrinsic value is $2.11 then the
time value must be $2.70 - $2.11 = 59 cents.28
Any option’s price can be broken down into the two components of intrinsic values and time values. The following formula will help:
Formula 1-2:
Total Value (Premium) = Intrinsic Value + Time Value
Total Value (Premium) = Intrinsic Value + Time Value
Using the July $35 call example, we know that the intrinsic value is $2.11 and the time value is 59 cents, so the total call value must be $2.11 intrinsic value + $0.59 time value = $2.70 total value. Figure 1-3 may help you to visualize the breakdown of time and intrinsic value:
Figure 1-3: Breakdown of Time and Intrinsic Values
If there is no intrinsic value then the option’s price is comprised totally of time value. For example, in Table 1-1, the July $37.50 is trading for $1.05. However, the stock is only $37.11. If you buy the $37.50 call, you’re buying a coupon that gives you the right to buy the stock for a higher price than it is currently trading. On the surface, it may seem that the $37.50 call has no value. But the real way to say it is that it has no intrinsic value; the $37.50 call has no immediate value. There may be value in the future, but there’s no immediate value at this time. The $1.05 premium on this call is made up of pure time premium. The only reason value exists on this call is because time remains.
Using Formula 1-2 for the July $37.50 call we have $0 intrinsic value and $1.05 time value, so the total value is $0 intrinsic value + $1.05 time value = $1.05 total value.
If you like mathematical formulas, you can find the intrinsic value of a call by taking the stock price minus the strike price (exercise price). If that number is positive, there is intrinsic value on the call option.
Intrinsic Value Formula for Calls:
Stock price – Exercise price = Intrinsic Value (assuming you get a positive number).
For example, the $35 call must have intrinsic value since $37.11 – $35 = $2.11. The $37.50 call, on the other hand, has $37.11 – $37.50 = -39 cents. Since this number is negative, there is no intrinsic value on this call.
For puts, we use the same reasoning but in the opposite direction. In Table 1-1, the July $40 puts are trading for $3.20. There is obviously an immediate benefit in holding the $40 put since we could sell our stock for $40 rather than the market price of $37.11. The amount of that benefit is $40 – $37.11 = $2.89. The intrinsic value is therefore $2.89. Because the put is trading for $3.20, the remaining value must be time value. The time value is $3.20 – $2.89 = 31 cents. Once again, using Formula 1-2 we see that the $2.89 intrinsic value + $0.31 time value = $3.20 total value.
If you wish to use mathematical formulas to find intrinsic value for puts, we can just reverse the call formula (remember, puts are like calls but they work in the opposite direction). For put options, if the exercise price minus the stock price is positive then there is intrinsic value. For example, the July $40 put has intrinsic value since $40 exercise price – $37.11 stock price = $2.89 intrinsic value. We know this is the intrinsic value since the result is a positive number. The July $35 put, on the other hand, has no intrinsic value since $35 exercise price – $37.11 stock price = -$2.11 (negative number).
Intrinsic Value Formula for Puts:
Exercise price – Stock Price = Intrinsic Value (assuming you get a positive number).
We can rearrange Formula 1-2 to come up with another useful formula for finding time value: Premium – Intrinsic Value = Time Value. We can abbreviate this formula as P – I = T, which looks like the word “pits.” Just remember that option formulas are the “pits” and you should have no trouble finding time values. What is the time value for the July $35 call? The premium is $2.70 and the intrinsic value is $2.11 so the time value is $2.70 – $2.11 = 59 cents.
Time Value for Calls and Puts:
Premium – Intrinsic Value = Time Value.
Intrinsic value is the key value to solve. If you can find intrinsic value, you can find time value. We can’t emphasize enough the importance of practicing by using the words “immediate benefit” or “immediate advantage” to determine if an option has intrinsic value. Formulas are nice if you are programming a computer but they do not allow you to understand why the formula works. Understanding the concepts is crucial to successful options trading. Use the formulas to check your answers.
Let’s revisit the thought process again for finding intrinsic value. For example, if someone asks you if the July $35 call in Table 1-1 has intrinsic value, you should ask yourself if there is an “immediate advantage” in being able to buy stock with the call for $35 when the stock is trading for $37.11. The answer is obviously yes. That means the $35 call has intrinsic value. How much intrinsic value? We just need to figure out the size of that advantage. If the stock is $37.11 and you can buy it for $35, there is $37.11 – $35 = $2.11 worth of advantage in the $35 call. The intrinsic value must be $2.11. Any remaining value in the option’s price is due to time value. Because the option is trading for $2.70, there must be $2.70 – $2.11 = 59 cents worth of time value.
What about the $40 put? Again, we know there is an “immediate advantage” in being able to sell your stock for $40 rather than the current price of $37.11, so this put has intrinsic value. How much intrinsic value? Again, we just need to find out how big the advantage is. If the owner of that put can sell stock for $40 when the stock is trading for $37.11, there must be $40 – $37.11 = $2.89 worth of intrinsic value. Any remaining value in the option’s price is due to time value. Because the option is trading for $3.20, there must be $3.20 – $2.89 = 31 cents worth of time value. Keep practicing these steps and intrinsic and time values will become second nature to you.
Moneyness
We just learned the difference between time and intrinsic values, and that allows us to understand some more option terminology. Options are generally classified by traders as in-the-money, out-of-the-money, or at-the-money, which are sometimes referred to as the “moneyness” of an option. An option with intrinsic value is in-the-money, while an option with no intrinsic value is out-of-the-money. An option that is neither in nor out of the money is at-the-money.
The phrase “in-the-money” is generally used to imply that something is profitable. If someone says their new business is in-the-money, it means they are making money, and that’s really what this term is implying with options. For example, in Table 1-1, the $32.50 and $35 calls are in-the-money since both have intrinsic value. The owners of these calls are able to buy the stock for less than it is currently trading and therefore have some real value in holding the option. The $40 call is out-of-the-money since there is no immediate benefit in holding it; there is no intrinsic value. Technically speaking, an at-the-money option has a strike that exactly matches the price of the stock. But since it is rare that the stock price will exactly match a particular strike, we usually label the at-the-money strike as the one that is closest to the current stock price. In Table 1-1, we’d say that the $37.50 strikes are at-the-money calls (even though they are technically slightly out-of-the-money).
If an option is very much in-the-money (usually by a couple of strike prices or more) the option is considered deep-in-the-money. If it is several strikes out-of-the-money it is considered to be deep-out-of-the-money.
For put options, the same definitions apply; all strikes with intrinsic value are in-the-money. For puts, this means that all strikes higher than the stock’s price are in-the-money. In Table 1-1, the $40 puts are in-the-money since they have intrinsic value. The $35 puts are out-of-the-money since they have no intrinsic value. The at-the-money strike will be the same for calls and puts, so the $37.50 puts would be considered the at-the-money strikes (even though they are technically slightly in-the-money).
The terms in-the-money, out-of-the-money, and at-the-money are used just for description purposes; it just makes it easier for option traders to describe types of options and strategies. For example, rather than tell someone that you bought some call options whose strike price is lower than the current value of the stock, it’s easier to say you bought some in-the-money calls.
Table 1-4 describes the moneyness for calls and puts:
Table 1-4
Call Options | |
Moneyness | Relationship to Stock |
In-the-money | Stock price > Strike price |
At-the-money | Stock price = Strike price |
Out-of-the-money | Stock price < Strike price |
Put Options | |
Moneyness | Relationship to Stock |
In-the-money | Stock price < Strike price |
At-the-money | Stock price = Strike price |
Out-of-the-money | Stock price > Strike price |
Most option exchanges, such as the CBOE, always provide at least one in-the-money and one out-of-the-money option for each month. This means that as the stock moves to new highs (or lows) then new strikes will be added to each expiration month.
The moneyness of an option affects the amount of time premium present. In general, in-the-money and out-of-the-money options will have the smallest time premiums. At-the-money options have the greatest amount of time premium. In other words, at-the-money options contain the highest amount of time value, and that value shrinks as we move toward the in-the-money or the out-of-the-money strikes.
The at-the-money option has the highest time value. Time value shrinks as we move in-the-money or out-of-the-money.
For example, Table 1-5 shows the time values for the July calls and puts in Table 1-1:
Table 1-5
Strikes | Call Time Value | Put Time Value |
$32.50 | 0.29 | 0.20 |
$35 | 0.59 | 0.50 |
$37.50 | 1.05 | 1.01 |
$40 | 0.35 | 0.31 |
Notice that the time values are relatively small for the in-the-money strikes ($32.50 call, $35 call, $40 put). The time values are also relatively small for out-of-the-money strikes ($40 call, $32.50 put, $35 put). It is the at-the-money strike ($37.50) that has the highest time value. Figure 1-6 shows the intrinsic and time values for only the call options in Table 1-4. You can see that the time value is very small for the $32.50 call because it is so far in-the-money. As we increase the strike price, the time premium gradually increases as well until we’re only left with pure time premium.
Figure 1-6
Parity
An option that is trading for purely intrinsic value (i.e., no time value) is trading at parity. For instance, assume that the underlying stock is trading for $46. If the $40 call is trading for $6 then it is comprised totally of intrinsic value and is therefore trading at parity. Options generally only trade at parity when there is little time remaining (usually a matter of hours).
Wasting Assets
We’ve learned that if you want a call or put option you must pay money for it. We also know that options expire at some time and that leads to an interesting question. Do options lose all of their value at expiration? After all, if the option is no longer good, how can it have any value?
While it is true that an option loses some of its value with each passing day, there is often a big misconception about how much of that premium is lost at expiration. There are traders who will tell you that all options become worthless at expiration, and that is simply not true. In an earlier section “Intrinsic Values and Time Values,” we said that all options must be worth at least their intrinsic value – and expiration time is no different. At expiration, all options lose only their time value but not their intrinsic value. It is only the time value portion of their price that slowly bleeds away with time. The intrinsic value remains intact. This is one of the reasons why it is so important to understand how to decompose an option into its intrinsic and time values. Certain strategies rely on the use of intrinsic values, while others make use of the time values. If you want to trade, hedge, or invest with options, you need to know how much of each value is present at each strike price.
To make sure you understand this concept, let’s look at the August $35 call in Table 1-1, which is trading for $3.60. We know there is $37.11 – $35 = $2.11 worth of intrinsic value and that means that the remaining value, or $3.60 – $2.11 = 1.49 worth of time value. If you were to buy this call and eBay closed at the same price of $37.11 at expiration, the $35 call would still be worth the intrinsic value of $2.11. It would not be worth zero. The only amount you would lose is the $1.49 worth of time premium. Remember, traders are paying the additional $1.49 over and above the immediate value because there is time remaining. Once time is gone (option is expired), then there can be no time value on the option, but the intrinsic value will remain. In Figure 1-6, the intrinsic value is bold and the time value is shaded. It is only the shaded portion that erodes with time. (Bear in mind this doesn’t mean that you cannot lose the intrinsic value. However, that value can be lost due to adverse stock movement only and not the passage of time.)
Because options lose some value with each passing day, they are calledwasting assets. There are some traders who reject the use of options since part of the option’s price deteriorates simply by the passage of time, but that is a thoughtless reason. The car you drive loses value over time. The same is true for the fruits and vegetables you buy. What about the computer you use? It doesn’t make sense to say that it’s not worthwhile to invest in assets whose value depreciates over time. You just have to be careful in the way you use them. Nearly all assets deteriorate over time, so don’t back away from options just because a portion of their value depreciates over time. Even the expensive factories that General Motors, Dell Computer, or Intel have built all lose value with each passing day, but the CEOs will tell you they have been very productive assets.
Time Decay
Time decay does not occur in a straight line over time. In other words, an at-the-money option with 30 days to expiration does not lose 1/30 of its value each day. Instead, it loses value slowly at first, which then progressively accelerates more and more each day. This is called exponential decay. Figure 1-7 shows the price of a 90-day option where we assume that nothing changes except the passage of time. You can see the rapid acceleration of decay as time gets near expiration – especially in the last thirty days.
Figure 1-7
Some texts will show this chart in the reverse order with the numbers on the horizontal axis increasing from 0 to 90, which is probably more mathematically correct since the numbers are ascending as we move left to right. However, it makes it awkward to read since you must make time move from right to left as we approach expiration. It’s usually easier for people to visualize time moving forward by moving from left to right. It’s a matter of preference as to which type of chart you use. Just realize that as you continue reading about options that you may encounter time decay charts that appear backwards but it’s just due to two different styles of presenting the same concept. The important point is that you understand that time decay is not linear. Because of this, it is usually to your advantage to buy longer periods of time and sell shorter periods of time. We will revisit this concept later but just realize for now that an option’s value does not decay in a straight line.
Before we leave this section, you might be wondering if there are any similarities between stocks and options. You might be surprised that options are similar to stock in many ways.
Table 1-4 describes the moneyness for calls and puts:
Table 1-4
Call Options | |
Moneyness | Relationship to Stock |
In-the-money | Stock price > Strike price |
At-the-money | Stock price = Strike price |
Out-of-the-money | Stock price < Strike price |
Put Options | |
Moneyness | Relationship to Stock |
In-the-money | Stock price < Strike price |
At-the-money | Stock price = Strike price |
Out-of-the-money | Stock price > Strike price |
Most option exchanges, such as the CBOE, always provide at least one in-the-money and one out-of-the-money option for each month. This means that as the stock moves to new highs (or lows) then new strikes will be added to each expiration month.
The moneyness of an option affects the amount of time premium present. In general, in-the-money and out-of-the-money options will have the smallest time premiums. At-the-money options have the greatest amount of time premium. In other words, at-the-money options contain the highest amount of time value, and that value shrinks as we move toward the in-the-money or the out-of-the-money strikes.
The at-the-money option has the highest time value. Time value shrinks as we move in-the-money or out-of-the-money.
For example, Table 1-5 shows the time values for the July calls and puts in Table 1-1:
Table 1-5
Strikes | Call Time Value | Put Time Value |
$32.50 | 0.29 | 0.20 |
$35 | 0.59 | 0.50 |
$37.50 | 1.05 | 1.01 |
$40 | 0.35 | 0.31 |
Notice that the time values are relatively small for the in-the-money strikes ($32.50 call, $35 call, $40 put). The time values are also relatively small for out-of-the-money strikes ($40 call, $32.50 put, $35 put). It is the at-the-money strike ($37.50) that has the highest time value. Figure 1-6 shows the intrinsic and time values for only the call options in Table 1-4. You can see that the time value is very small for the $32.50 call because it is so far in-the-money. As we increase the strike price, the time premium gradually increases as well until we’re only left with pure time premium.
Figure 1-6
Parity
An option that is trading for purely intrinsic value (i.e., no time value) is trading at parity. For instance, assume that the underlying stock is trading for $46. If the $40 call is trading for $6 then it is comprised totally of intrinsic value and is therefore trading at parity. Options generally only trade at parity when there is little time remaining (usually a matter of hours).
Wasting Assets
We’ve learned that if you want a call or put option you must pay money for it. We also know that options expire at some time and that leads to an interesting question. Do options lose all of their value at expiration? After all, if the option is no longer good, how can it have any value?
While it is true that an option loses some of its value with each passing day, there is often a big misconception about how much of that premium is lost at expiration. There are traders who will tell you that all options become worthless at expiration, and that is simply not true. In an earlier section “Intrinsic Values and Time Values,” we said that all options must be worth at least their intrinsic value – and expiration time is no different. At expiration, all options lose only their time value but not their intrinsic value. It is only the time value portion of their price that slowly bleeds away with time. The intrinsic value remains intact. This is one of the reasons why it is so important to understand how to decompose an option into its intrinsic and time values. Certain strategies rely on the use of intrinsic values, while others make use of the time values. If you want to trade, hedge, or invest with options, you need to know how much of each value is present at each strike price.
To make sure you understand this concept, let’s look at the August $35 call in Table 1-1, which is trading for $3.60. We know there is $37.11 – $35 = $2.11 worth of intrinsic value and that means that the remaining value, or $3.60 – $2.11 = 1.49 worth of time value. If you were to buy this call and eBay closed at the same price of $37.11 at expiration, the $35 call would still be worth the intrinsic value of $2.11. It would not be worth zero. The only amount you would lose is the $1.49 worth of time premium. Remember, traders are paying the additional $1.49 over and above the immediate value because there is time remaining. Once time is gone (option is expired), then there can be no time value on the option, but the intrinsic value will remain. In Figure 1-6, the intrinsic value is bold and the time value is shaded. It is only the shaded portion that erodes with time. (Bear in mind this doesn’t mean that you cannot lose the intrinsic value. However, that value can be lost due to adverse stock movement only and not the passage of time.)
Because options lose some value with each passing day, they are calledwasting assets. There are some traders who reject the use of options since part of the option’s price deteriorates simply by the passage of time, but that is a thoughtless reason. The car you drive loses value over time. The same is true for the fruits and vegetables you buy. What about the computer you use? It doesn’t make sense to say that it’s not worthwhile to invest in assets whose value depreciates over time. You just have to be careful in the way you use them. Nearly all assets deteriorate over time, so don’t back away from options just because a portion of their value depreciates over time. Even the expensive factories that General Motors, Dell Computer, or Intel have built all lose value with each passing day, but the CEOs will tell you they have been very productive assets.
Time Decay
Time decay does not occur in a straight line over time. In other words, an at-the-money option with 30 days to expiration does not lose 1/30 of its value each day. Instead, it loses value slowly at first, which then progressively accelerates more and more each day. This is called exponential decay. Figure 1-7 shows the price of a 90-day option where we assume that nothing changes except the passage of time. You can see the rapid acceleration of decay as time gets near expiration – especially in the last thirty days.
Figure 1-7
Some texts will show this chart in the reverse order with the numbers on the horizontal axis increasing from 0 to 90, which is probably more mathematically correct since the numbers are ascending as we move left to right. However, it makes it awkward to read since you must make time move from right to left as we approach expiration. It’s usually easier for people to visualize time moving forward by moving from left to right. It’s a matter of preference as to which type of chart you use. Just realize that as you continue reading about options that you may encounter time decay charts that appear backwards but it’s just due to two different styles of presenting the same concept. The important point is that you understand that time decay is not linear. Because of this, it is usually to your advantage to buy longer periods of time and sell shorter periods of time. We will revisit this concept later but just realize for now that an option’s value does not decay in a straight line.
Before we leave this section, you might be wondering if there are any similarities between stocks and options. You might be surprised that options are similar to stock in many ways.
How are Options Similar to Stocks?
- Options are securities.
- Options trade on national SEC (Securities Exchange Commission)-regulated exchanges.
- Option orders are transacted through market makers and retail participants with bids to buy and offers to sell and can be traded like any other security.
How Do Options Differ From Stocks?
- Options have an expiration date, whereas common stocks can be held forever (unless the company goes bankrupt). If an option is not exercised on or before expiration, it no longer exists and expires worthless.
Options exist only as “book entry,” which means they are held electronically. There are no certificates for options like there are for stocks.
- There is no limit to the number of options that can be traded on an underlying stock. Common stocks have a fixed number of shares outstanding.
· Options do not confer voting rights or dividends. They are strictly contracts to buy or sell the underlying stock or index. If you want a dividend or wish to vote the proxy, you need to exercise the call option.
Key Concepts
1) The intrinsic value of an option represents the “immediate benefit” in using the option.
2) Any value in the option above the intrinsic value is the time value.
3) In-the-money options have intrinsic value. Out-of-the-money options have no intrinsic value.
4) At-the-money options carry the highest time value.
5) You only lose your time value at option expiration. Any intrinsic value must remain.
