An option premium or price is made up of two components time value and intrinsic value. Since options are time sensitive, the time value component of an option contract erodes to zero as the expiration date approaches. If an option is "In the Money" the premium will also reflect an intrinsic value.This is the real value of the option that is determined by the difference between the option strike price and the price of the underlying security.
A call is option is characterized as being "At the Money" when the Price of the underlying security and the strike price of the option is the same or very close. For example let's say that XYZ is trading at $50.00/share and the XYZ, 1 month 50 dollar strike call option is trading at $2.00/contract. Remember that option premiums are listed on a per share basis and each contract represents 100 shares. In this example the call option buyer has the right to buy the shares at $50.00. With the shares of XYZ trading at $50.00 this option has no intrinsic value. With XYZ trading at $50.00 per share and a call strike price of 50, the option premium is made up entirely of time value. If the share value does not increase within the 1 month time frame the time value component will depreciate and the option will expire worthless.
A call option is referred to as being "Out of the Money" when the stock is less than the strike price. For example with shares of an underlying security trading at $45.00 per share an XYZ, 1 month call option with a 50 strike might be trading at.30 cents. By purchasing the call option, the option holder has the right to buy shares of the underlying security at 50 dollars. Since the stock is currently trading at 45 dollars, this option is considered to be "Out of the Money" and has no intrinsic value. With the share price at 45 dollars, the 50 strike option is made up entirely of time premium. As with the "At the Money" option, if the share value does not rise above the strike price by the expiration date, the option will expire worthless.
A call option is referred to being "In the Money" when the stock is greater than the strike price. If XYZ is trading at 55 dollars per share, a call option with a 50 strike and 1 month until expiration might have a premium of $5.50. In this case the call buyer has the right to own the shares at 50 dollars. With XYZ trading at 55 dollars per share, the call option has a 5.00 intrinsic value. With a 50 dollar strike and XYZ trading at 55 dollars, the $5.50 premium can be broken down into two components. By subtracting the strike price from the stock price we can determine that the option has an intrinsic value of 5.00. We then subtract the intrinsic value from the premium to determine the time value which in this example is $0.50 cents.
A put option is referred to as being "At the Money" when the price of the underlying and the strike price of the option is equal or close in value. With XYZ trading at 50 dollars per share, a 1 month, 50 strike put option may be trading at $1.90 In this example, the put buyer has the right to sell the underlying shares at 50 dollars however, since the share value is equal to the strike price of the put there is no intrinsic value. The 1.90 price of the option is made up entirely of time premium which means that if the share value does not drop below the strike price of the put, the option will expire worthless.
A put option is considered to be "Out of the Money" when the share value of the underlying security is greater than the strike price. With XYZ trading at $55.00 per share, the XYZ, 1 month put option with a 50 dollar strike price might be trading at 25 cents. In this case, the put buyer has the right to sell XYZ shares at 50 dollars However since the shares are still trading at 55 dollars the put option has no intrinsic value. With the share value priced at 55 dollars and a 50 strike the 25 cent put premium is made up entirely of time value. If the share value remains above 50 dollars the put option will expire worthless
A put option is characterized as being "In the Money" when the share value of the underlying is less than the strike price. With XYZ at 45 dollars per share a 50 strike put option with 1 month until expiration may be trading at $5.40. The put buyer has the right to sell the underlying shares at $50.00 even though XYZ is trading at $45.00. We determine the intrinsic value of the put option by subtracting the share value from the strike price. In this example a 50 dollar strike minus a share value of 45 dollars reflects an intrinsic value of 5.00 The 5.40 premium can be broken down into two parts. By subtracting the 5.00 intrinsic value, we can determine that the time value component of the option premium is.40 cents If the share value remains the same, the time value component will depreciate to zero leaving only the intrinsic value.
As with the call option, an "in the money" put will exercise automatically if it has an intrinsic or real value on expiration. Which option to use will depend on the objectives of the trader or investor. Each category of options has certain advantaged and disadvantages An "At the Money" option will begin to reflect an intrinsic value as soon as the underlying starts to move in the anticipated direction. These options tend to be the most liquid and the disadvantage is that these options are the most expensive from a time value perspective.
So how do you pick the right option? "Out of the Money" options require the least amount of capital and provide the investor or trader with the greatest amount of leverage. However, a greater move in the underlying is necessary to realize an intrinsic value. As a result, the time component of the premium will erode much quicker and consequently "Out of the Money" options have a higher probability of expiring worthless. An "In the Money" option will be more expensive because the intrinsic value is added to the time value of the premium. Because an "In the Money" option is more expensive the option buyer has a less leveraged position However the impact of time depreciation is lessened. The disadvantage of an "In the Money" option is that it requires more capital up front to purchase and can lose its intrinsic value very quickly with an adverse move in the underlying security. Once the intrinsic value disappears, time depreciation will accelerate.
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