Valuation of Options

The option's value is called its premium. This is the current value of each option contract. It is expressed as a single numeral with two decimal places. For example, an option might be priced currently at 2.40. This means it is worth $240.

Value contains three distinct and separate parts, making valuation of options more complex than that of stock. With stock, the current market value is widely understood as the price per share.

With options, the premium is broken out into components based on the proximity between strike and current value of the underlying stock, time to expiration, and volatility of the underlying stock.

The first value is called intrinsic value. This is the value equal to the number of points that the stock is above a call's strike or below a put's strike. For example, a 35 call has intrinsic value of three points ($300) when the stock is worth $38 per share; and a 45 put has intrinsic value of two points ($200) when the stock is worth $43.

Intrinsic value can only exist when the current value of stock is greater than the call's strike or less than the put's strike. In this condition, the option is described as in the money.

In comparison, no intrinsic value exists when the current value of stock is at or below the call's strike, or when the stock's value is at or above the put's strike. When the value and strike are equal, the option is at the money and when the value is lower than the call's strike or higher than the put's strike, the option is Out Of The Money.

The second of three components making up the option's overall premium value is called time value. This is the value assigned solely to the amount of time remaining until expiration. The longer the time remaining in the life of an option, the higher the time value will be. The rate of decline is very slow when options have a long time remaining; as expiration approaches, the time decay of the option accelerates. The rate of decline is faster, so the total history of time value looks much like a 30-year amortization chart; the principal balance falls gradually and then picks up speed in the final years. For options, the same path is seen in the decline of time value.

The third and final type of option premium is the volatility value, usually described as implied volatility of the option. This is also called extrinsic value. Whereas both intrinsic and time value are entirely predictable, extrinsic value is where all of the unknown changes take place, based on volatility of the underlying stock and proximity between current value and strike of the option. Extrinsic value often offsets changes in intrinsic value, resulting in less price reaction to movement in the underlying stock. For example, when in the money an option moves only two points while the stock's price moves three points. The one-point difference reflects a change in extrinsic value.

The option premium is complex when you realize that it contains three distinct parts. However, both intrinsic value and time value are easily understood and completely predictable. So all variables in option valuation are involved with extrinsic value. The factors affecting implied volatility found in extrinsic value include:

The premium is complex and changes are likely to be subtle, even when price movement (notably in the money) is obvious. Valuation of options combines known values (intrinsic and time value) with the great unknown influences on the stock's price.

To better understand how extrinsic value works, imagine this situation: A call's strike is 7 points above current value of the stock, meaning it is deep out of the money. The option expires in nine months. The combination of the extended life and the proximity make this a very cheap option. However, within the next month, the stock rises by nine points, so the option is two points in the money. The overall value of the option in terms of intrinsic and extrinsic value increases; intrinsic value moves from zero to two points, but the overall value of the option has risen by five points.

This is a puzzling situation until the relationship between pricing and volatility is understood. In this case, time value has declined slightly because expiration is one month closer. Intrinsic value is equal to the points in the money. However, the difference between 7 points out and 2 points in is significant. It is not only the 9-point change that matters, but the change in status. Now the option is in the money but still has eight months until expiration. Its extrinsic value is much greater now because the opportunities for further intrinsic changes have increased greatly due to the movement in the underlying stock.

To complicate matters even more, this example is only hypothetical. There is no predictability in how extrinsic value will change based on dramatic movement in the underlying stock. There are only tendencies and likely extrinsic adjustments, but you also have to remember that volatility is an uncertain matter in pricing of all markets. Making a distinction between the three types of valuation clarifies some of the mysteries of option pricing, but uncertainty—even when an option is in the money—is still the ruling attribute of the overall premium level.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

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