| Lesson 5- Option Premium |
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The market value of an option contract, known as the "premium", is made up of two separate factors: Intrinsic Value (moneyness)The intrinsic value of an option contract is the part of the options value that is In-the-Money (ITM). Extrinsic Value (time value)The extrinsic value of an option contract is the part of the value that is Out-of-the-Money (OTM). To recap, intrinsic value is the real value of the contract and the extrinsic value is the time value of the contract. Some option contracts posses both values while others possess only one. For example, an option contract that has only extrinsic value is said to be Out-of-the-Money because it contains only Time Value. Time value is a combination of the time until expiration and the possibility that the contract will finish In-the-Money. As expiration approaches and/or the possibility becomes less likely, the extrinsic value decreases. We will discuss this topic in more detail later. We have discussed three new terms in this lesson which need to be explained. They are: In-the-Money (ITM)The intrinsic value of an option contract is different for call and put options. A call option is ITM if the underlying stock price is greater than the strike price. A put option is ITM if the underlying stock price is less than the strike price. An ITM option has both intrinsic value and time value. Out-of-the-Money (OTM)The time value of an option contract is also different for call and put options. A call option is OTM if the underlying stock price is less than the strike price. A put option is OTM if the underlying stock price is greater than the strike price. An OTM option has no intrinsic value and only time value. There is also At-the-Money Options, which are: At-the-Money (ATM)A call or put option is ATM if the underlying stock price is the same as the strike price. An ATM option has no intrinsic value and only time value. There are some simple formulas to calculate intrinsic value and time value: Call Option Intrinsic Value = Underlying Stock Price - Strike Price Call Option Time Value = Call Premium - Call Intrinsic Value Put Option Intrinsic Value = Strike Price -Underlying Stock Price Put Option Time Value = Put Premium - Put Intrinsic Value Example #1- On November 20th, Exxon Mobil is currently trading at $74.65 per share with 1 day until the November contracts expire. The November 70 call premium is $5.05 and the November 70 put premium is $0.46. Example #2- On December 20th, Apache Corp. is currently trading at $97.07 per share with 29 days until the December contracts expire. The December 100 put premium is $5.20 and the December 100 call premium is $2.40. The put option in Example #1 and the call option in Example #2 have no intrinsic value- only time value. In Example #1 there is 1 day until expiration. In Example #2 there are 29 days until expiration. Option contracts with more time until expiration typically have more time value. |