Option Premium Valuation: Time and Intrinsic Value
An option premium is the amount that a holder of an option contract pays for the right to buy or sell a number of shares of a security at the strike price up until a predefined date. The premium can fluctuate in value much like a typical stock price. Premium prices also share in the same volatility that a stock price does and in many ways will react to the same information flowing in the market such as fundamental variables, rumors, etc. For example, if a call option providing the right to purchase the underlying stock at the strike price seems like a better deal, then investors will pay a higher premium for that option thereby increasing the premium price. So from this we can conclude that premium prices can fluctuate from one trading day to the next.
The premium is composed two components: the option’s time value and intrinsic value. Unexpired options will always have a time value which is the time remaining until the option contract expires. An option expiring in 6 months has a greater time value than an option expiring in 4 months because there is a greater amount of “time” for the price of the underlying security to fluctuate.
Intrinsic value can be defined as the amount the holder of the option contract stands to gain by exercising the option. This value will vary depending on the price of the underlying security. For example, a call option with the right to purchase HD stock at $30 (Buy 1 HD May 30 Call @ 2) will become more attractive when the stock price rises from $28 to $41 because the holder of the contract can purchase the stock at the strike price of $30 and immediately sell it at $41 yielding a $11 per share gain. The intrinsic value in this case is $11 (41-30 = 11). If, however, HD were to fall in price below the $30 strike price, the option contract would not acquire an intrinsic value.
An example:
Josh is pretty happy now that 2 weeks ago he bought 5 HD May 40 Calls @ 3. Because of market factors, the stock’s price has increased to $45 which would be a gain of $5 per share if Josh were to exercise the contract now. But he thinks prices are only going to improve, so he buys another option for another 500 shares of HD. However because the stock price has risen, the premium price has also gone up. Josh will now purchase 5 HD May 40 Calls @ 5.25. To practice the concept of intrinsic value, what part of the $5.25 premium is the intrinsic value? When HD is trading at $45, the intrinsic value is $5 per share. The remaining $.25 is the option’s time value.
Investments of all kinds have a similar trait in common- market factors. Behind the scenes of time and intrinsic values, many market factors such as fundamental variables, investor expectations, etc. all affect option prices. Options investors need to have an increased awareness of quality of an option’s underlying security and volatility in the market and must routinely investigate stability in price and health of the companies represented by an options contract.
Now that you have an understanding of an option’s premium, you may be asking yourself at what point you make a profit. This is what investors refer to as “in the money”, “at the money”, and “out of the money”. To determine whether an option is in the money or out of the money, you must always look at it from the buyer’s point of view. A call option would be in the money when the current market price is above the strike price. Example: If you owned 1 HD May 50 Call, it would be in the money when the current market price for HD is above $50 per share.
Inversely, a put option is in the money when the current market price is below the strike price. Example: If you owned 1 HD May 50 Put, it would be in the money when HD’s stock price is trading below $50 per share. Out of the money is exactly the opposite of in the money. For example if you own 1 HD May 50 put, it would be out of the money when HD’s stock price is trading above the $50 strike price. An option is at the money when the strike price equals the current market price.
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