Option Value Review
Recap of Module 2: Stock Option Valuation
- An options cost or market value is often called the premium or ask price.
- With a stock price "increase", a Call options premium will increase (you'll make money), and the Put options premium will decrease (you'll lose money).
- With a stock price "decrease", a Put options premium will increase (you'll make money), and the Call options premium will decrease (you'll lose money).
Option Value and Strike Price...
The strike/exercise price of an option is the "price" at which the stock will be bought or sold when the option is exercised.
There are three different terms for describing the stock price to strike price relationship:
- Out of the Money: Calls (stock price "lower" than strike price), Puts (stock price "higher" than strike price).
- At the Money: stock price and strike price are the "same" or close to being the same.
- In the Money: Calls (stock price "higher" than strike price), Puts (stock price "lower" than strike price.
The more an option is in-the-money (ITM) the more expensive it will be, because it has more value to the holder. The value is called intrinsic value.
The farther an option is out-of-the-Money (OTM), the cheaper it will be.
An at-the-Money (ATM) option, price wise, is in the middle and is slightly cheaper than an "ITM" option.
Option Value and Extrinsic Value...
The extrinsic value (time value) of an option is the dollar value that is placed on the remaining life of the option.
- The farther out you go with the options expiration month the higher the cost will be.
- The extrinsic value portion of the options price dwindles down on a daily basis, this is called time decay.
- Once an option moves to ITM then it will start gaining value rapidly and the effect of time decay will be negligible because intrinsic value will take over.
- Sell your option positions 30 days before they expire.
Volatility...
Option Volatility is a measure of risk / uncertainty.
- High volatility equals a higher option premium
- Low volatility equals a lower option premium
Option volatility is broken down into 2 components:
- Historical Volatility: tells us how volatile something has been in the past.
- Implied Volatility: is the markets view on how volatile things will be in the future.
Value Illustration...
Here is an over simplified illustration so you can visually see how all the components come together to make the option price:
ITM ($3) + Time Value ($1) + Volatility ($1) + Interest rate ($.60) + Dividend ($.10) = $5.70 Option cost/premium
If the overview has helped to reinforce everything you learned then I think you're ready for Module 3. Proceed to Module 3: Lesson 1 "Option Trading Strategies".
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Free Options Course Learning Modules
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Module 1: Option Basics |
Module 2: Option Value |
Module 3: Basic Strategies |
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Module 4: Stock Charts |
Module 5: Technical Indicators |
Module 6: The 7-step process I use to trade stock options |
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