How Are Options Values Determined?
What an option contract is worth to an investor can be primarily be measured by how likely it is to meet the trader's expectations. This refers to whether or not the option is, or is likely to be, either in- or out-of-the-money.
For example, a call option will be considered in-the-money if the current market value of the shares of the underlying stock or other asset is above the option's exercise price. Conversely, the call option will be considered out-of-the-money if the share price of the underlying stock or other asset is below the options exercise price.
With put options, if the current market value of the underlying stock shares is below the exercise price of the option, then the option is considered to be in-the-money. And, the put option will be out-of-the-money if the price of the underlying stock shares or other asset is above the options strike price. Thus, if an option is not in-the-money at the time of its expiration date, then is will expire worthless.
When determining an options premium, there are two primary considerations. These include the intrinsic value of the option and it time value. An options intrinsic value is the amount by which the option is considered in-the-money.
The time value of an option is determined as the difference between whatever the options intrinsic value is and what the premium of the option is. Therefore, the longer the amount of time for market conditions to work in the investors favor, then the greater will be the time value of that option.
An option that is at-the-money has some distinct advantages as well as some disadvantages over shares of stock an over an in-the-money option. For example, an option that is at-the-money will be cheaper than both the actual stock itself as well as the in-the-money option. Thus, there will be a lesser amount of capital requirement for the investor and less total risk in the transaction. However, in this case, there could be an issue with the in-the-money options extrinsic value.
In order for an investor to profit from purchasing an option that is at-the-money, they will need the underlying stock shares to move very quickly. Due to the fact that the option has so much intrinsic value, the investor could actually end up battling against the options daily rate of decay as it moves towards the expiration date. In this case, the movement of the underlying stock will need to occur quickly enough and large enough so as to offset the amount of money that the investor could lose each day as the options expiration draws closer.
An option that is out-of-the money can also present some of the same advantages and disadvantages. This option will be even less than the at-the-money option, so this can mean more leverage as well as less risk. However, in this case, the underlying stock will need to move more than either the in-the-money or the out-of-the-money option in order for the options to become profitable.
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