Options Valuation and Prices - How do options get priced?

 Summary: How do you evaluate options? What determines the price? Learn the answers to both questions in this miniseries.

Unlike stocks, options have an expiration date. Unless a company goes bankrupt or buys back all its stock, the stock investor always has the choice to wait for a price correction. Sometimes that wait represents the triumph of hope over experience, but more on that elsewhere.

That expiration date makes calculating an option's value more complicated, but also more accessible to some of the powerful statistical tools developed over the last few decades.

Two of the more common methods for evaluating options involve measuring their intrinsic value and their time value.

The 'intrinsic value' is the amount by which the option's strike price is 'in-the-money'. Strike price is the contractually set price at which the underlying asset would be bought or sold, if the option were exercised. 'In-the-money' means the strike price is lower (for a call option) and higher (for a put option) than the current market price.

For call options:  IV = Asset Market Price – Call Strike Price
Since options have an expiration date, but are purchased on some prior date their value changes as the expiration date nears. That change in time results in a decay of the value of the option as a trading instrument.

An option with two days remaining is generally worth less than one that gives the investor three months to act. At expiration the option is either in-the-money, in which case profits are possible, or it's out-of-the-money and the investor incurs a potential loss.

Time value is the amount by which the price of an option exceeds its intrinsic value.

For call options:  TV = Call Premium – Intrinsic Value

[For put options:
IV = Put Strike Price – Asset Market Price
TV = Put Premium – Intrinsic Value

Note: The 'premium' is simply the cost of the call or put.]

For options that are 'at-the-money' (strike price = current price), or 'out-of-the-money' (strike price higher/lower (call/put) than current market price) the option has no intrinsic worth at that time. It only acquires value in so far as the market price can change, i.e. it has only time value.

For example, suppose MSFT (Microsoft) has a current market price per share of \$27 for a June 30 call. The '30' refers to the strike price, not the expiration date. If the premium is \$2, the option is out-of-the-money - since: \$27 - (\$30 + \$2) = -\$5.

I.e. if you bought the call and exercised it immediately you'd lose five dollars (plus commission costs).

Since, the option has no intrinsic value (negative intrinsic value isn't allowed), why would anyone execute such a trade?

Because an out-of-the-money is less expensive than one in the money and the further out-of-the money the cheaper it is. There are many trading strategies that utilize this fact as a hedge or for potential profit. Given a three month period, the market price may well rise to more than cover the premium and produce a profit. That's what makes options trading speculative.

In Part II, we discuss the effect of Time Value further.