Volatility and Implied Volatility
Please read Characteristics and Risks of Standardized Options before deciding to invest in options. Option Value Where an option gets its price can seem like smoke and mirrors when first learning about option trading, but it is actually pretty simple. These values change based on three inputs: strike price in relation to the stock price, implied volatility, and time until expiration. Intrinsic Value - Call Option This is the most straightforward value to understand.
An option has intrinsic value if it will be worth something at expiration.
Option Value Videos
To calculate how much intrinsic value an option has, all we have to do is measure the difference between my ITM strike and the stock price. If an option is out of the money OTMit has no intrinsic value. That is why the option has no worth at expiration, and is considered to be OTM. Call options have intrinsic value if they are below the stock price.
Call options that are above the stock price have no intrinsic value, as they would be worthless at expiration. Intrinsic Value - Put Option Intrinsic value works the same way with put options, but on the opposite side of the coin.
Since a put option is the right to sell shares at a certain strike, these options have intrinsic value if they are above the stock price.
The intrinsic value calculation is the same - it is just the difference between our ITM strike and the stock price. Just like calls, if a put option is OTM it has no intrinsic value.
This renders our put useless at expiration. Put options have intrinsic value if they are above the stock price. Put options that are below the stock price have no intrinsic value, as they would be worthless at expiration. So why do OTM call and put options still have value if they will be worthless at expiration?
Understanding the Options Premium
Because there is still time and implied volatility of the underlying. This is known as extrinsic value. Extrinsic Value Extrinsic value is a little more complicated, because it has multiple factors that affect it. But the main factors are time and implied volatility. At the money ATM options are closest to the stock price, and have the most extrinsic value.
Extrinsic value is very similar to a standard bell curve if there is no volatility skew. The time factor of extrinsic value is the easiest to understand.
- Understanding the Options Premium
- Option Premium Definition
- This implied volatility does not have to be calculated by the trader, since most option trading platforms provide it for each option listed.
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It is very similar what the option premium consists of an insurance contract. Regardless of what someone is insuring, they will have a higher total premium if they insure it over the course of a year compared to 30 days.
If we picture ourselves as the insurance agency offering you the option as protection and you sell an OTM option that has 60 days until expiration, it will be worth much more than that same option that has 7 days to expiration.
There is more time associated with the contract, which translates directly into a larger extrinsic value.
How to Calculate an Option Premium
As we get closer to expiration, the extrinsic value will dissipate. On expiration day, options trade very close to their intrinsic value as there is not much time left until expiration and not a lot of time for the underlying to move in price.
This I will help to make money us to our next contributing factor, which is implied volatility IV. Implied volatility is simply speculation of where an underlying could go over the course of a year.
It is derived from the current option market of an underlying. If a person is a skydiver, their premium would be through the roof.
Option Premium – Everything You Need to Know
They would have a lot more perceived risk associated with their lifestyle, and a lot more uncertainty of what might happen to them. They would have what the option premium consists of very high implied volatility, and therefore a higher insurance premium. If a person was a homebody that did not partake in risky hobbies, their premium would be much lower. The risk of something happening to them is low, as there is not much perceived risk associated with their what the option premium consists of.
They would have a very low implied volatility, and therefore a lower insurance premium.
Understanding those factors and the placement of the strike compared to the stock price will give you a better understanding of why an option has a certain price.