|
There are two
components making up the option premium: intrinsic value (true value)
and time value.
1.
Option Premium = intrinsic value + time value.
2.
Intrinsic value = stock price - strike price. (for call option)
3.
Intrinsic value = strike price - stock price. (for put option)
Let’s review the
Option Chain for IBM stock at the closing bell on Wednesday January 7,
2009:
Let’s look at IBM
Jan 80 Call Option IBMAP:
The option
premium for IBMAP is $8.06.
Using formula 2,
we calculate intrinsic value:
Intrinsic value =
stock price – strike price = $87.79 - $80 = $7.79.
Using formula 1,
we calculate time value:
Time value =
Option premium – intrinsic value = $8.06 - $7.99 = $0.27.
In this case, the
option premium of $8.06 has $7.79 intrinsic value and $0.27 time value.
The reason we
have little time value here is because there is little time left from
January 7 to the option expiration day on January 16. At the last minute
on option expiration day, we will see almost the same number for option
premium and intrinsic value due to the diminishing of time value. Time
value is usually the greatest at ATM options.
Let’s look at IBM
Jan 90 Put Option IBMMR:
The option
premium for IBMMR is $3.40.
Using formula 3,
we calculate intrinsic value:
Intrinsic value =
strike price – stock price = $90 - $87.79 = $2.21.
Using formula 1,
we calculate time value:
Time value =
Option premium – intrinsic value = $3.40 - $2.21 = $1.19.
In this case, the
option premium of $3.40 has $2.21 intrinsic value and $1.19 time value.
Notice that IBMMR
has greater time value than IBMAP because IBMMR option is closer to
at-the-money option.
Please notice there
is no “negative intrinsic value”. OTM options have only time value and
no intrinsic value. That is why beginners should not trade OTM options
because if the trade does not go our way, time value will diminish
quickly with every day passing by and we will end up with a loss.
Dennis Phan 潘家墉
05
March 2009
|
