Premiums & exercise

Premiums

The premium is the current market price of an options contract. Like any market price, it’s influenced by supply and demand:

• If more investors want to buy an option, the premium tends to rise.
• If more investors want to sell an option, the premium tends to fall.

Market demand for an options contract is generally influenced by two components: intrinsic value and time value.

Intrinsic value is the amount of profit the holder would have if the option were exercised right now. For example, an option that gives you the right to buy a stock at $50 when the stock is trading at $60 has $10 of intrinsic value. In general, the more intrinsic value an option has, the higher its premium.

Time value reflects how much time is left until the option expires. More time means more opportunity for the market price to move in a favorable direction. Because of that added opportunity, more time value generally means a higher premium.

Option premiums can be calculated using this formula:

$\text{Premium}=\text{intrinsic value}+\text{time value}$

Intrinsic value is also called the “in the money” (ITM) amount of the contract. A contract is in the money when exercising it would produce a benefit (a return) for the holder.

You can summarize how intrinsic value works for calls and puts like this:

Calls:

• Go in the money (gain intrinsic value) when the market rises

• Go out the money (lose intrinsic value) when the market falls

Puts:

• Go in the money (gain intrinsic value) when the market falls

• Go out the money (lose intrinsic value) when the market rises

To represent this visually:

If a contract is in the money, it has intrinsic value. If a contract is out of the money, it has no intrinsic value. A contract is at the money when the strike price and the market price are the same.

Market prices fluctuate, so an option can move in and out of the money many times before expiration. A lot can change in the nine months* that standard options exist, which is why time value is such an important part of an option’s premium.

*Standard options maintain expirations of up to nine months from issuance. However, LEAPS options maintain expirations of up to 3 years from issuance.

Calculating intrinsic value is straightforward once you know three things:

• The option type (call or put)
• The strike price
• The market price of the underlying security

Let’s work through a few examples.

1 ABC Jan 50 call when the market price is $55

This option has $5 of intrinsic value (it’s “in the money” by $5). Now try a few on your own.

1 ABC Jan 50 call when the market price is $70. How much intrinsic value does the option have?

1 ABC Jan 50 call when the market price is $40. How much intrinsic value does the option have?

1 ABC Jan 50 call when the market price is $50. How much intrinsic value does the option have?

A call’s intrinsic value depends on ABC’s market price relative to the $50 strike price:

• If the market price is above the strike price, the call has intrinsic value (it’s ITM).
• If the market price is at or below the strike price, the call has no intrinsic value.

Some test takers remember this as “call up.”

Notice that we haven’t used the premium to determine intrinsic value. Also, being “in the money” or “out of the money” doesn’t automatically mean you’ve made or lost money on the trade. Intrinsic value only describes the option’s value if exercised right now. Your overall gain or loss depends on the full picture, including the premium you paid or received.

Now let’s look at puts using similar numbers.

1 ABC Jan 50 put when the market price is $55

This option has no intrinsic value and is “out of the money” by $5. Try a few more.

1 ABC Jan 50 put when the market price is $70. How much intrinsic value does the option have?

1 ABC Jan 50 put when the market price is $40. How much intrinsic value does the option have?

1 ABC Jan 50 put when the market price is $50. How much intrinsic value does the option have?

A put’s intrinsic value depends on ABC’s market price relative to the $50 strike price:

• If the market price is below the strike price, the put has intrinsic value (it’s ITM).
• If the market price is at or above the strike price, the put has no intrinsic value.

Some test takers remember this as “put down.” As you can see, puts move opposite calls.

---

Intrinsic value is one part of the premium; time value is the other. The more time an option has until expiration, the more opportunity the stock price has to move above or below key levels.

Assume you can choose between buying an option that expires in one week versus an option that expires in nine months. If both cost the same, the nine-month option would be more attractive because it gives the market more time to move in your favor.

In practice, though, the nine-month option typically costs more (assuming the same option type and strike price). From the writer’s perspective, a longer-lived option creates more risk, so writers generally demand higher premiums. Bottom line: the longer the time until expiration, the more expensive the option tends to be.

---

Time value can’t be calculated directly without more advanced models. However, you can find an option’s time value using simple algebra and the premium formula:

$\text{Premium}=\text{intrinsic value}+\text{time value}$

Let’s look at some examples.

1 ABC Mar 35 call @ $5 when ABC’s market price is $36. What is the intrinsic value and time value?

Can you figure it out?

If you purchased this call for $500 ($5 x 100 shares), $100 ($1 x 100 shares) pays for the immediate benefit provided by intrinsic value. The remaining $400 ($4 x 100 shares) pays for time, which gives the market price a chance to rise further.

Let’s try another:

1 ABC Dec 70 call @ $3 when the market price is $68. What is the intrinsic value and time value?

When an option has no intrinsic value, the premium is 100% time value. If you purchased this option, you wouldn’t be paying for any immediate exercise benefit. The $300 premium ($3 x 100 shares) pays only for time, which gives the market price a chance to rise above $70.

How about this one?

1 ABC Apr 95 put @ $9 when the market price is $92. What is the intrinsic value and time value?

If you purchased this put for $900 ($9 x 100 shares), $300 ($3 x 100 shares) pays for the immediate benefit provided by intrinsic value. The remaining $600 ($6 x 100 shares) pays for time, which gives the market price a chance to fall further.

Last one.

1 ABC Aug 20 put @ $4 when the market price is $21. What is the intrinsic value and time value?

Again, when an option has no intrinsic value, the premium is 100% time value. If you purchased this put, you wouldn’t be paying for any immediate exercise benefit. The $400 premium ($4 x 100 shares) pays only for time, which gives the market price a chance to fall below $20.

Sidenote

Delta

As discussed in this chapter, option premiums are influenced by two primary factors:

• The underlying stock’s market price (intrinsic value)
• The option’s time value

Investors can use Delta to estimate how an option’s premium may change when the underlying stock’s market price changes.

Start with this example:

Long 1 ABC Jan 50 call at $5

ABC’s market price = $50

If the long call’s Delta is 0.50, the premium is expected to move $0.50 for every $1.00 move in ABC’s stock price. If ABC rises to $51, the call’s premium would be expected to increase to $5.50 (up by $0.50). Delta is an estimate, so it won’t be accurate 100% of the time.

Delta for calls is measured from 0 to 1, while Delta for puts is measured from -1 to 0. This difference reflects how each option type gains intrinsic value:

• Calls gain intrinsic value when the market price rises (“call up”)
• Puts gain intrinsic value when the market price falls (“put down”)

Now use the same setup, but with a put:

Long 1 ABC Jan 50 put at $5

ABC’s market price = $50

If the long put’s Delta is -0.50, the premium is expected to move $0.50 for every $1.00 move in ABC’s stock price. If ABC rises to $51, the put’s premium would be expected to decrease to $4.50 (down by $0.50).

Exercise

When an option is in the money, holders may consider exercising their contracts. Exercising usually involves a quick phone call or an online request. However, not every option can be exercised at any time.

Options have two different exercise styles: American and European.

American-style options allow exercise to occur at any time. Equity (stock) options are American-style.

European-style options only allow exercise to occur at expiration. Index options, which derive their value from fluctuating index values, are almost always European-style. This style was introduced to reduce the anxiety of option writers. Even if an option goes in the money, the writer knows they don’t need to be concerned about exercise until expiration.

American- and European-style options only describe when exercise is allowed. Both styles can be traded at any time up to expiration. So, if you want to exit a European-style option before expiration, you don’t need to wait - you can complete a closing transaction instead.

Sidenote

FLEX options

As the name suggests, FLEX options allow investors to customize the attributes of a contract. The customizable components include:

• Exercise style (American or European)
• Expiration date
• Exercise price

Otherwise, the other components of FLEX options are the same as standard contracts. Equity FLEX options cover 100 shares of the underlying stock, premiums are quoted on a ‘per share’ basis, and settle on the same schedule (T+1 for trades, T+1 for exercises).

Key points

Option premiums

• Premium = intrinsic value + time value
• Longer expiration, higher time value

Delta

• Predicts premium change based on underlying stock price movements
• For example, a Delta of 0.50 means:
  • For every $1 the underlying stock moves, the premium changes by $0.50
• Delta ranges:
  • For calls: 0.00 to 1.00
  • For puts: -1.00 to 0.00

Call options

• In the money (ITM) when the market rises above the strike price
• Out the money (OTM) when the market falls below the strike price

Put options

• In the money (ITM) when the market falls below the strike price
• Out the money (OTM) when the market rises above the strike price

American-style options

• Can be exercised at any time
• Typical for stock (equity) options

European-style options

• Can only be exercised at expiration
• Typical for index options

FLEX options

• Contracts with customizable components:
  • Exercise style (American or European)
  • Expiration date
  • Exercise price