Option Investor
Educational Article

Let's Start At The Beginning

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By Lee Lowell

This being my first article of the New Year, I'd like to begin from the top and explain some basics of options trading. Some of you might find this elementary, some of you might find this as a nice review, and some of our new readers might find this as your first step.

We know that there are two types of options: calls and puts. What you can do with them is practically endless. Each one can be bought or sold as a single contract or can be combined to form almost any strategy to fit your risk profile and time frame. I'm not going to discuss all the types of strategies you can create with options at this time, but I will discuss what an option is and how its premium is derived.

The price of an option that is bought or sold on the options exchanges is called the "premium." The premium isn't a number that is magically pulled out of the air. It's a number that is mathematically calculated using a pricing formula that can be solved with an options calculator. There are a few different option pricing models, but the first and most popular one is called the "Black-Scholes" model. This is named after the two gentlemen that created the formula.

The pricing model takes into account six different inputs that are used to derive the option's premium. They are:

1. underlying stock price
2. strike price of the option
3. days until option expiration
4. volatility
5. current interest rates
6. dividends of the stock

Once all these inputs are fed into the model and calculated, the resulting number is the premium of your option.

Let's take a closer look at some of the inputs. The first two items are self explanatory but there is a name for the relationship between these two numbers. It is called "intrinsic value." The relationship between the stock price and strike price will determine if the option is in-the-money, at-the-money, or out-of-the-money. Any option that is in-the-money (call or put), has intrinsic value. Any option that is at-the-money or out-of-the-money has no intrinsic value.

A call option has intrinsic value and is in-the-money if the strike price is lower than the stock price. A put option has intrinsic value and is in-the-money if the strike price is higher than the stock price.

A call option has no intrinsic value and is out-of-the-money if the strike price is higher than the stock price. A put option has no intrinsic value and is out-of-the-money if the strike price is lower than the stock price.

Example:
YHOO trading at $30 per share
$25 call=$8, is $5 in-the-money, so it has $5 of intrinsic value
$35 call=$3, is out-of-the-money, so it has $0 of intrinsic value

$35 put=$8, is $5 in-the-money, so it has $5 of intrinsic value
$25 put=$3, is out-of-the-money so it has $0 of intrinsic value

To figure out the in-the-money portion, just take the difference between the stock price and the strike price. Whatever amount of points the option is in-the-money, that's how much intrinsic value it has.

The last four inputs on the list also have a name for their relationship to the option premium. It is "extrinsic value" (or "time premium"). These inputs add extra value to the option above and beyond its intrinsic value. "Days to expiration" and "volatility" are really the ones that add the extra value whereas "interest rates" and "dividends" play a very small role. So I will only concentrate on days to expiration and volatility.

Going back to our YHOO example:
YHOO trading at $30 per share
$25 call=$8, $5 of intrinsic value and $3 of extrinsic value
$35 call=$3, $0 of intrinsic value and $3 of extrinsic value

$35 put=$8, $5 of intrinsic value and $3 of extrinsic value
$25 put=$3, $0 of intrinsic value and $3 of extrinsic value

No matter what, all options have extrinsic value, but only options that are in-the-money will have intrinsic value.

Intrinsic + Extrinsic = Option Premium

Figuring out the intrinsic value is the easy part. Figuring out the extrinsic value is a little tricky so I will spend some time clarifying it. We all know that longer dated options have more time until expiration. The more time we have, the more the underlying stock can move in our favor. Thus, we will pay higher prices for the opportunity to get it right. If you are bullish on a stock but not sure when it will move higher, then you should buy some LEAP calls. This gives you plenty of time to be right. But the extra months of time will add more extrinsic value to the premium. For example, a one month out-of-the-money call option may have $1 of extrinsic value whereas a 12 month LEAP call may have $6 of extrinsic value. You're paying $500 more for that option for the extra eleven months of opportunity.

Just remember, the intrinsic value (or in-the-money value) will always be the difference between the stock price and the strike price. But the extrinsic value is constantly changing because the days to expiration are always getting smaller.

"Volatility" is the other important component of the extrinsic value and is the most difficult to quantify. It too adds extra value to the option just as the "days to expiration" do. Volatility is a term that signifies the erraticness of the stock in question. The more erratic the stock, the higher the volatility. The less fluctuations of the stock, the smaller the volatility. The volatility number is derived from its own formula using past closing prices of the stock and is expressed in % terms. Once this number is figured out, it is then added into the option calculator along with the other five inputs. A higher volatility number will bump up the extrinsic value level and a lower volatility number will decrease the extrinsic value.

Example:
YHOO trading $30 per share with 45% volatility:
$25 call=$8, $5 of intrinsic value and $3 of extrinsic value
$35 call=$3, $0 of intrinsic value and $3 of extrinsic value

YHOO trading $30 per share with 85% volatility:
$25 call=$12, $5 of intrinsic value and $7 of extrinsic value
$35 call=$6, $0 of intrinsic value and $6 of extrinsic value

As you can see, as we bump up our volatility number, the price of the option goes up from the extrinsic portion. It is very important that you get a handle on how to figure and use volatility because that will help you to better price the option correctly.

So that's it. In a nutshell, the price of the option is comprised of six components. Two of which are considered intrinsic value and four are considered extrinsic value. The relationship between the stock price and the strike price, the days to expiration, and the volatility of the stock are the most important features.

I hope this review hasn't bored too many of you. It's always good to re-visit the basics.

Good luck

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