Premiums & exercise

Premiums

The premium reflects the current market value of an options contract and is directly influenced by demand. If more investors purchase an options contract, the premium rises. If more investors sell an options contract, the premium falls.

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

Intrinsic value equals the holder’s profit if the option is exercised. For example, an option providing the right to buy a stock at $50 when the stock’s market price is $60 maintains $10 of intrinsic value. The more intrinsic value an option has, the more expensive the premium.

Time value represents the time left until an option expires. The longer the time until expiration, the more potential for the market to move. Therefore, more time value creates a more valuable option with a higher premium.

Option premiums can calculated by using this formula:

$\text{Premium}=\text{intrinsic\hspace{0.33em}value}+\text{time value}$

Intrinsic value is also referred to as the “in the money” (ITM) amount of the contract. Contracts are “in the money” when the exercise of a contract provides some form of return to the holder. You can sum up intrinsic value with calls and puts in this way:

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” and has intrinsic value, we can safely assume the holder will (eventually) exercise the contract. If a contract is “out of the money” and has no intrinsic value, the contract will (eventually) expire. Also, a contract is “at the money” if the strike and market prices are the same.

Of course, market prices fluctuate daily, so options can go in and out of the money numerous times before expiration. A lot can change in the nine months* that options exist, which is why time value is a significant factor when determining a contract’s worth.

*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 fairly simple if you know what you’re looking for. All you need is the option type, the strike price, and the market price of the underlying security. Let’s take a look at a few examples:

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

This option has $5 of intrinsic value (“in the money” by $5). Let’s see if you can tackle some 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?

As you can see, the call’s intrinsic value depends on ABC stock’s market price in relation to the $50 strike price. When the market price is above the strike price, it has intrinsic value (is “in the money”). Some test takers remember this by the phrase “call up.” When the market price is at or below the strike price, it has no intrinsic value.

Notice how we didn’t mention premiums with intrinsic value. Also, the “in the money” or “out of the money” amount doesn’t necessarily result in a profit or loss. Intrinsic value (or lack of it) only tells part of the story. The overall gain or loss depends on the “big picture,” which includes the option’s premium.

Let’s take a look at how puts work 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. Let’s try some more examples:

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?

The put’s intrinsic value depends on ABC stock’s market price in relation to the $50 strike price. When the market price is below the strike price, it has intrinsic value (is “in the money”). Some test takers remember this by the phrase “put down.” When the market price is at or above the strike price, it has no intrinsic value. As you may have noticed, puts are perfectly inverse to calls.

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Intrinsic value is one part of the premium; time value represents the other component. The more time an option has until expiration, the more potential for the stock price to rise or fall below certain levels.

Assume you can choose between buying an option expiring in one week versus an option expiring in nine months. You’re definitely taking the nine-month option if both cost the same, as it provides much more time for the contract to go “in the money” and gain intrinsic value.

That’s not the real world, though. A nine-month option is worth a lot more than a one-week option (assuming same option type and strike price). But, because of its cost, you may not go with the nine-month option. From the writer’s perspective, they’re taking on much more risk with a nine-month option than a one-week option. Therefore, writers demand higher premiums for options with longer lifetimes. Bottom line - the longer the time until expiration, the more expensive the option.

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Time value cannot be directly calculated without using complicated formulas and equations. However, you can find an option’s time value through simple algebra. Let’s refresh ourselves with the premium formula:

$\text{Premium}=\text{intrinsic value}+\text{time\hspace{0.33em}value}$

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 were to purchase this call for $500 ($5 x 100 shares), $100 ($1 x 100 shares) is paying for the immediate benefit the intrinsic value provides. The remaining $400 ($4 x 100 shares) is paying for time, which provides the opportunity for the market price 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% comprised of time value. If you were to purchase this option, you’re not paying for any immediate benefit. The $300 premium ($3 x 100 shares) is paying only for time, which provides the opportunity for the market price 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 were to purchase this put for $900 ($9 x 100 shares), $300 ($3 x 100 shares) is paying for the immediate benefit that intrinsic value provides. The remaining $600 ($6 x 100 shares) is paying for time, which provides the opportunity for the market price 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% comprised of time value. If you were to purchase this put, you’re not paying for any immediate benefit. The $400 premium ($4 x 100 shares) is paying only for time, which provides the opportunity for the market price to fall below $20.

Exercise

When an option is “in the money,” holders consider exercising their options contracts. The process of exercising usually involves a quick phone call or an online request. However, not every option can be exercised at any time. Options can have two different exercise styles: American and European.

American style options allow for 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 of option was introduced to reduce the anxiety of option writers. Although an option may go in the money, the writer knows they don’t need to be concerned about an exercise until expiration.

American and European-style options only relate to the ability to exercise a contract. Both allow option trades to occur at any time leading up to expiration. Therefore, an investor who wants to “get out” of a European-style option does not necessarily need to wait until expiration. They can simply perform a closing transaction!

Key points

Option premiums

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

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