Learn options trading

How options are valued

Options can by tricky for first timers to comprehend but it's worth the effort because they can be a good investment vehicle.

You should already have an understanding of how options work. If you don't check out this page and then come back... Renting Shares for Beginners

So one of the difficult questions about options is, how are they valued.

To understand the principle behind option value, let's look at a basic example of a Call option. Suppose you bought some tickets to a concert that is coming up in three months time. You paid $200 for two tickets.

Two weeks later Chris decides to buy some tickets but doesn't want to spend the $200 now, so Chris offers you $20 for the right to buy your tickets for $250 in two months time, that's two weeks before the concert.

You decide to accept the offer and you receive `the $20 from Chris. Now let's consider this scenario.

The concert tickets turned out to be in hot demand and sold out quickly. With a month to go before the concert, people are offering $300 for two tickets.

How much is the option that Chris bought worth now? Well Chris has the right to buy two tickets from you for $250 and could sell them immediately for $300 so at the very least Chris could sell the Option for $50. But remember the Option still has two weeks until expiry. Kim thinks that people will be offering even more over the next couple of weeks so Kim offers Chris $55 for the Option.

So the Option that Chris bought from you for $20 was sold to Kim for $55. Chris made a $35 profit.

Kim now owns the Option to buy your tickets for $250. A week passes and people are now offering $350 for the tickets so Kim is looking to make a healthy profit. But then the organisers' advise a change of venue that has double the capacity. They release a flood of new tickets, all for the original $200.

All of a sudden the Option that Kim bought for $55 is worth virtually nothing, because the Option entitles Kim to buy the tickets from you for $250 in a week's time, but people can buy them from the organisers for just $200. There is a slight chance that these new tickets will sell out very quickly pushing the price of the tickets to about the $250 exercise price, but it's only a small chance so the Option is now only worth 20 cents.

So we can see that the value of an Option is made up of two elements, an "Intrinsic" element plus a "Time" element. At the time Chris sold the Option to Kim for $55, the "Intrinsic" value was $50 i.e. the difference between the current price ($300) and the exercise price of the option ($250). And the "Time" value was $5; that was the premium that Kim paid for the time that the Option had to run.

At the time the organisers released the new tickets the Option only had a small amount of "Time" value i.e. 20 cents. It had no "Intrinsic" value because the current price of $200 was below the exercise price of $250.

This example shows how a "Call Option" works. Call options are used in the Renting Shares strategy. When renting shares, you first buy the shares (in our example the tickets) and then sell the Call Option.

You can use Paper-Trader to view Option Prices.  The screen below is from an actual trade using Paper-Trader. We can see from this the effect of stock price and time on the option value. The left hand chart shows the stock price from the start of the trade, which was 04 Feb 2002, through to Paper-Trader's current date of 08 April 2002. The right hand chart is the option price, and it's a Call option.

At the bottom you can see that there's 11 days to go to expiry and if we clicked the buttons to the right of the main Paper-Trader date we'd step forward and be able to view our trade to completion.

Can you see in the early part of this trade the option value moves up and down in sync with the stock price. But as time wears on the option time decay comes more into play. See how the current stock price is back up to about where it was at the start of the trade. But the call option value has dropped dramatically. This is the time decay taking affect.

As a general rule an option will lose two thirds of its value in the last one third of its life.

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