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Without getting too complex about how they are derived, every options trader does need a basic understanding of the two options pricing components that make up the pricing or valuation of an option. You do not need to know the detailed models such as Black-Scholes etc., but if you understand the underlying concepts, then you will hold an important key to profitable option trading.
The price of any option (call or put) has two components:
INTRINSIC VALUE: An option is said to have intrinsic value if the option is in-the-money (ITM). Intrinsic value reflects the amount, if any, by which an option is In-the-money (ITM). In fact, an option may not have any intrinsic value at all. By definition, at-the-money (ATM) and out-of-the-money (OTM) options do not have intrinsic value.
For example:
Call's intrinsic value = ABC's stock price - Call's strike price
If a call option has a strike price of $25, and the stock price is $24, then the price of the option has no intrinsic value; its only value is time value. If, having bought the option, the stock price goes up to $26, you now have $1 worth of intrinsic value. The remainder of the option price is time value.
Put's intrinsic value = Put's strike price - ABC's stock price
If a put option has a strike price of $25, and the stock price is $26, then the price of the option has no intrinsic value. It gains intrinsic value when the stock price falls to below $25. So, if the stock falls to $24, then the option has $1 worth of intrinsic value. The remainder is time value.
TIME VALUE: Time Value is the amount of money you pay for the length of time until the option expires. If you buy an OTM option (Call or Put), you pay only for the time value. If you buy an ITM option, you pay for the time value PLUS the intrinsic value. The further away from the strike date that you buy or sell the option, the more you pay for that option.
As you get closer to expiration, the value of the option decreases more and more rapidly, until it is at zero on the strike date.
Time value increases as volatility increases, because if the stock is more volatile, it has a greater chance of moving into desired prices during the time period; it is therefore more valuable; it is also more risky.
NOTE VERY WELL:Learn about Time Value in options trading.
When you BUY option calls and puts, Time Value is your ENEMY!! This is why Swing Trading is so important. Because you are planning to hold the option (either a call or a put) for two to 10 days, you can minimise the effect of time value.
When you SELL calls, puts and spreads, Time Value is ON YOUR SIDE, and is some other guy's enemy (the guy that bought your option).
How is change in Time Value measured?
The Greek value THETA is the key measurement that concerns us:
THETA: This measures the rate at which the price of the option changes over time.
For example: If the THETA of an option is -0.50, then your option value will decrease by approximately $0.50 every day until the contract expires.
NOTE: The closer you are to expiration, the more the THETA grows - the price of the option decreases at an increasing rate over time.
Why is this important? If you BUY calls or puts, THETA or TIME DECAY becomes your enemy. If THETA is high, you must plan to not hold on to the option for too long! TIME DECAY will eat up the profits made from an increase in the stock price.
If you SELL calls, puts or credit spreads, you simply have to hold on to the option, watching as its value decreases every day until it expires worthless (unless it is ITM), at which point you pocket your profits and do it again!
Time Value can be your ENEMY and EAT your profits;
It can be your FRIEND and earn your profits!
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