Options Investing E-learning - Premium & Valuation

In addition to their potential intrinsic value, options also have another element of value: the option premium. The premium has to be paid by the buyer, which is then transferred to the option seller. To a certain extent, the purchase of an option contract can be compared to the acquisition of an insurance policy, where a premium is charged by the insurance seller. The insurance buyer pays the premium in advance of the period during which the insurance agreement is valid. The contract embeds a potential claim, which will only be lifted if certain conditions are met.

The option holder has a right. The option writer takes the risk for a potential obligation, for which the option writer receives a financial compensation. This is called the option premium. The potential obligation to take or make delivery incorporates risk. This is why the writer needs to receive a premium from the option buyer.

The option premium (price) is based on the price of the underlying value and the movement of that price (volatility), but also on factors such as the remaining lifetime of the option, and on supply and demand in that particular option series.

The higher the price volatility, the larger the price risk, but that also means more opportunity. In the case of high price volatility, the chance of a significant price change is large. Price volatility must be considered when pricing an option. The future price volatility must be included in the pricing process.

A Rational market participant should be indifferent to buy an asset now or in time. Pricing of products should be accordingly. Therefore, the forward price or future price should be equal to the ‘spot price’ plus cost of carrying the underlying asset forward in time. The cost of carrying a stock forward in time are the cost of capital (interest) minus the financial compensation (dividend). Interest raises the future or forward price of an asset. A higher future price will lead to a higher value of call options and a lower value of put options. Dividend payments lower the cost of carrying an asset forward in time because the holder of the security faces a cash inflow. Such cash inflows lower the future or forward price of an asset.

The strike price is the price at which that underlying value can be transacted as stated in the option agreement. Obviously, the strike price must be compared to the price of the underlying value. In case the price of the underlying value exceeds the strike price at expiration, a call option has intrinsic value. On the contrary, when the price of the underlying value is below the strike price, a put option has intrinsic value.

The longer the time to maturity, the more time there is for the price of the underlying asset to make a move. In other words, the longer the time to maturity, the more chance there is for the price of the underlying value to change and the more significant this move can be. Therefore, long-term options are priced at higher premiums than short-term options.

European-style options can only be exercised at expiration. American-style options may be exercised during their lifetime, but at the latest at expiration. When an option is exercised before maturity it is called “early exercise”. Early exercise is often performed for equity options on the day before the underlying share will be traded ‘ex-dividend’. The more flexibility an option offers, the higher its price. Hence, American style options are priced (somewhat) higher than European style options.

The premium or value of an option consists of two components: the intrinsic and the extrinsic value. The extrinsic value is also known as “time value” or “expectations value”. The time value is the extra premium on top of the intrinsic value. The time value reflects the possibility of a possible move beyond the strike price before the option expires. At expiration of an option, only intrinsic value applies, if it applies at all (i.e., only when the option is “in-the-money”).