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Option Premiums Explained – Valuing a Stock Option

Welcome back, future traders! You now know what stock options are, the components of a stock option, and what a put or a call option means from my previous post. You are ready and eager to learn more about how to build a future towards financial independence.

It is time to figure out how the price of a stock option premium is valued and priced. It is important to know how a stock option premium is calculated, how it is valued, and what factors contribute to the price of a premium. Continue reading to have stock option premiums explained : intrinsic value, time value, and implied volatility.

Review: A stock option premium is the amount that the buyer pays the seller for a put or a call option. The price of a premium is represented for each individual stock share, however each option requires at least 1 contract. 1 contract equals 100 underlying shares.

Intrinsic Value – In-the-Money or Out-of-the-money?

The difference between the strike price and the current market price of the underlying stock is called the intrinsic value.

Let’s say that Mary is an investor that believes that the company stock for Nike (NYSE: NKE) is going to increase in price. Mary decides to buy 1 call contract of NKE with a strike price of $100 that expires on May 15. The market price of NKE increases to $105. The intrinsic value of the call option would be $5. Mary would make a $500 profit at this time if she exercised her call option [(105-100)x100x1). This is also called being “in-the-money.”

Mary would be “out-of-the-money” by $5, with a $500 loss if she buys 1 call contract at a strike price of $100 that expires May 15 and then the market price decreases to $95. There would be no intrinsic value. The more “in-the-money” the option is, the higher the cost of the premium.

A call is “in-the-money” when the strike price is lower than the current market price of a stock. A put is “in-the-money” when the strike price is higher than the current market stock price. Reversely, a call is “out-of-the-money” when a strike price is higher than the current market price, and a put is “out-of-the-money” when a strike price is lower than the current market price

In-the-money-vs-out-of-the-money

Time Value – Mark Your Expiration Dates

Option contracts are available with weekly, monthly, or quarterly expiration dates depending on the company. They are typically on a set date that corresponds with others in the stock market. The longer the time period before the option expires, the more valuable it is, thus leading to a higher premium due to increased risk. The closer to the expiration date, the lower the premium as the option is worthless once it expires.

Implied Volatility

Volatility refers to future predicted market price fluctuations within a particular company or stock. If a stock’s future market prices are predicted to be relatively stable, it has a low implied volatility. The reverse is also true; if a stock is predicted to have market prices that swing very high and/or low, the implied volatility is high. A stock with high implied volatility will typically require a larger premium while a stock with lower implied volatility will have a lower premium cost.

Conclusion

Intrinsic value, time value, and implied volatility are the three major components to understanding the value and cost of a stock option contract. These components are combined to determine the premium costs. The price range of a premium varies with call and put strike prices; the further out-of-the-money the strike price is, the higher the cost of the premium and the higher the risk associated with that call or put.

4 Replies to “Option Premiums Explained – Valuing a Stock Option”

  1. What platform does one use to trade options? I need to keep reading to understand more clearly.
    Is that something you can do on ThinkorSwim? It’s sort of like playing black or red. You either end up sinking or swimming. No in between.

    1. Hi Teresa,
      I am not familiar with ThinkorSwim. I am currently using Ameritrade and E*Trade which both have options. I think you have to apply to do options and they usually set you at a specific lower trading level until you get more advanced.

      Best regards,
      Sonia

  2. I really needed to read this to learn the basics of stocks. You’ve explained it so well in simple terms and made it accessible to the wider audience out there who are interested in investing money in this area of business.

    Thank you for educating us all.

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