An option contract is a financial instrument whereby the option’s holder can buy or sell the underlying asset at a certain price during a predetermined period. For instance, a call stock option might grant its owner the right to buy 500 shares at a price of $30 per share at any time between the date the option was created and one year later. An investor uses a call or put option to enhance their investment strategy.
Market Strategy and Call Options
The stock call option locks in the price of a share and, in so doing, protects against an increase in the market price of that underlying asset. For instance, an investor who believes the market price of a certain stock will rise may purchase a call option and effectively purchase the stock at a discount.
If a stock’s market price rises significantly following the investor’s purchase of the option, they stand to profit from that investment.
Market Strategy and Put Options
Like the call option, an investor uses a put option to lock in a stock price. In this case, the option protects against a decrease in the stock’s market price. The put option manages the investor’s market risk by ensuring that they can sell a stock at a certain price, which effectively allows them to sell the stock at a premium and limit the loss if an unanticipated fall in the stock’s price occurs.
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Buying options requires a smaller commitment of an investor’s capital than does, say, short-selling shares. Consequently, with options, the investor can take a significant position with relatively little capital upfront.
The Option’s Premium
The purpose of an option is to secure big payoffs in an “up” market while minimizing losses in a “down” market. In either case, an investor’s successful use of option contracts requires an understanding of the option premium, or the amount an investor will pay for the option. Only then will the investor recognize a good deal and act on it.
An option premium formula consists of two parts: the option's intrinsic value and the time value of the option contract.
The Option’s Intrinsic Value
The cash an investor will receive if she exercises an option at a certain time is referred to as the option’s intrinsic value. As the following example illustrates, the intrinsic value equals the difference between its strike or exercise price and the underlying asset’s current market value, assuming that difference in the two is positive.
Option Is “In the Money”
To better understand the option premium, assume an investor buys a call option for a strike price of $40 and that the market price of a share is $45. In this case, the intrinsic value of the share equals $45 minus $40, or $5. In the event that the investor exercises a call contract for 100 shares, they’ll receive $500. In this case, the option is “in the money."
Option Is “Out of the Money”
In contrast, if the investor buys a call option for a strike price that is $60 and the stock’s market price per share is $50, the option has no intrinsic value because no market exists for an option when the market price of the underlying asset is less than the strike price. When this occurs, the option is “out of the money."
The Option’s Time Value
The time value of an option is the price an investor will pay over and beyond the option’s intrinsic value. This dollar value reflects the investor’s confidence in the option’s future market value, which is based on an assumed future market price of the related stock. The greater the stock’s price volatility the higher the option premium.
Status of Options Contract
An options contract that’s “out of the money” today, could be “in the money” tomorrow if the option market price of the contract’s underlying asset increases. This fact illustrates the time value of an option contract in that an investor may pay above an option’s intrinsic value in anticipation of an increase in the value of the related asset.
For instance, assume that an investor buys a call option with a strike price of $55 and that the market price of the underlying asset dips from $60 to $50. In that case, the option is “out of the money.” If the stock rallies to a price of $65, the option is back “in the money.”
Read More: Call Options and Dividends
The Option Premium Over Time
An option premium reflects the relationship between a call option’s strike price and a stock’s market price. For instance, assume the following: an investor buys a call option at a strike price of $30 (the option purchase price) when the stock price is $45, and the option’s intrinsic value is $15.
Also, assume another investor is willing to pay an additional $10 per option to hold the one-year option contract because they believe the stock’s market price will increase to $60. At that point, the option premium equals the sum of the intrinsic value of $15 plus the $10 time value, for a total option premium of $25. The dollar amount of the time value increases over time, meaning the greater the time remaining until the option’s expiration, the greater the option’s time value.
- With most financial instruments, "premium" refers to a price above an objective value. For instance, an investor might call an option's time value a "time premium." Yet the option premium, unlike other security premiums, includes both the intrinsic and extrinsic value of the option.
Billie Nordmeyer is an IT consultant of 25 years standing. As a senior technical consultant for SAP America and Deloitte Touche DRT Systems, a business analyst, senior staff, and independent consultant, Billie has worked across the retail, oil and gas, pharmaceutical, aeronautics and banking industries. Billie holds a BSBA accounting, MBA finance, MA international management as well as the Business Analyst and Software Project Management certificates from the Cockrell School of Engineering at the University of Texas at Austin.