The value of equity options is derived from the value of their underlying securities, and the market price for options will rise or decline based on the related securities’ performance. There are a number of elements to consider with options.
The Strike Price
The strike price for an option is the price at which the underlying asset is bought or sold if the option is exercised. The relationship between the strike price and the actual price of a stock determines, in the unique language of options, whether the option is in-the-money, at-the-money or out-of-the-money.
- In-the-money: An in-the-money Call option strike price is below the actual stock price. Example: An investor purchases a Call option at the $95 strike price for WXYZ that is currently trading at $100. The investor’s position is in the money by $5. The Call option gives the investor the right to buy the equity at $95. An in-the-money Put option strike price is above the actual stock price. Example: An investor purchases a Put option at the $110 strike price for WXYZ that is currently trading at $100. This investor position is In-the-money by $10. The Put option gives the investor the right to sell the equity at $110
- At the money: For both Put and Call options, the strike and the actual stock prices are the same.
- Out-of-the-money: An out-of-the-money Call option strike price is above the actual stock price. Example: An investor purchases an out-of-the-money Call option at the strike price of $120 of ABCD that is currently trading at $105. This investor’s position is out-of-the-money by $15. An out-of-the-money Put option strike price is below the actual stock price. Example: An investor purchases an out-of-the-money Put option at the strike price of $90 of ABCD that is currently trading at $105. This investor’s position is out of the money by $15.
The premium is the price a buyer pays the seller for an option. The premium is paid up front at purchase and is not refundable - even if the option is not exercised. Premiums are quoted on a per-share basis. Thus, a premium of $0.21 represents a premium payment of $21.00 per option contract ($0.21 x 100 shares). The amount of the premium is determined by several factors - the underlying stock price in relation to the strike price (intrinsic value), the length of time until the option expires (time value) and how much the price fluctuates (volatility value).
Intrinsic value + Time value + Volatility value = Price of Option
For example: An investor purchases a three-month Call option at a strike price of $80 for a volatile security that is trading at $90.
Intrinsic value = $10
Time value = since the Call is 90 days out, the premium would add moderately for time value.
Volatility value = since the underlying security appears volatile, there would be value added to the premium for volatility.
Top three influencing factors affecting options prices:
- the underlying equity price in relation to the strike price (intrinsic value)
- the length of time until the option expires (time value)
- and how much the price fluctuates (volatility value)
Other factors that influence option prices (premiums) including:
- the quality of the underlying equity
- the dividend rate of the underlying equity
- prevailing market conditions
- supply and demand for options involving the underlying equity
- prevailing interest rates
Other costs? Don’t forget taxes and commissions.
As with almost any investment, investors who trade options must pay taxes on earnings as well as commissions to brokers for options transactions. These costs will affect overall investment income.
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