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Options Valuation - Part 2

In Part I, we outlined an example. MSFT (Microsoft) stock with a current market price of $27, and a June 30 call option with premium of $2. (I.e. an option whose characteristics are: contract to buy 100 shares of MSFT by June 16 at a strike price of $30. Remember the '30' refers to the strike price, not the expiration date.)

Since that option was out-of-the-money it sold at a discount. That's 'compensation' for the greater risk entailed in buying the call. As that June 16 date nears, the premium will go down. A June 30 call option will sell for less on June 10th than it did on March 16th.

That 'decay' characteristic turns speculating into more than a game of blind chance. The game becomes one of calculated risks.

An option that's in-the-money has intrinsic value. (See Part I).
The deeper in-the-money it is the more its price tends to move like that of the underlying asset. For example, suppose the current market price were not $27, but $35 and the cost of the call 3$. Now,

$35 - ($30 + $3) = $2.

[In this case, the Intrinsic Value = $35 - $30 = $5. Note, it doesn't include the premium.]

That doesn't seem like much of a gain, but remember one contract is for 100 shares, the $2 is per share. So $2 x 100 = $200. Even subtracting a $10 commission, the immediate potential profit is $190.

[Note: all examples are for 'American style' options - an option that can be exercised anytime before expiration. 'European style' options, such as those written on indexes rather than individual equities, are exercised AT expiration.]

But traders who sell options aren't likely to give away money. Any opportunity of the kind described would be subject to immediate arbitrage. Arbitrage is buying and rapidly selling in two different markets to take advantage of just such differences in price, to reap quick profits.

That tends to push prices in the direction of breakeven.

As a result, time value becomes one of the primary factors for profiting from options investing. That factor has two basic determinants: (1) time remaining until expiration, and (2) difference between strike price and current market price.

Two options with different strike prices but the same maturity will have two different time values. Similarly, two options with the same strike price, but two different maturities will have two different time values. In both cases, the premium will be affected by the size of the difference.

For the sake of simplicity, assume the underlying asset price doesn't change and that the strike prices of different options is the same. The remaining variable is the amount of time until expiration. Any chart of options premium vs time-to-expiration, then, will show a declining line. The option closer to expiration, has a lower time value.

Also note, the option with an out-of-the-money strike price will have a premium closer to zero, the closer its maturity is to expiration. That illustrates the effect of time value.

The concept is simple - as expiration nears, premium prices fall. Using the idea in a trading strategy is less so. For advice on that, see elsewhere in this series.

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