In Options Trading, buyers pay Premium, which is the price of the option they wish to control. Now, this options price is determined by many variables that impact the profitability of the options contract. Therefore, the options traders need to understand these variables to make the right market decisions.
In this article, we will understand the basics of how options are priced and the various factors that affect this pricing. If you wish to learn more about Options Trading, join Universal Investment Strategies, the best way to learn stock trading.
Basics of Option Prices
Options contracts allow the buyers to buy or sell an underlying security at a pre-determined price, called the Strike Price. The Strike Price is a fixed value, but simply having a lower or higher strike price will not yield profit. To gain profit, the price of the underlying security should move in such a manner that it also covers the Premium.
Given below are the two main factors that affect the Premium price and ultimately, the profitability of the options contract.
Intrinsic Value
Intrinsic value is the amount of Premium that is covered by the difference between the current stock price and the strike price. This intrinsic value is one of the major factors that affect the profitability of the contract. It is called intrinsic value because most of the Premium’s price can be covered with this value.
For instance, consider an investor who owns a call option on a stock. Let’s say this stock is currently on trade at $50 per share, and the strike price is $45. Assuming the Premium to be $7, the intrinsic value can be calculated by the difference of current stock price and the strike price, which is $5. This $5 is called the intrinsic value as it covers the $5 of the $7 Premium.
Time Value
The time value of an option can be simply understood as the time remaining until the options expiry. Now, the time remaining until the option is expired has a monetary value associated with it, because more time means more chance of profit, and vice versa.
In other words, Time Value is a part of the Premium that the buyer of an option pays above the intrinsic value to gain the profit of owning that contract for a given period. Due to this, Time Value is also known as the Extrinsic Value.
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The intrinsic and extrinsic values of the Options are major driving factors that ultimately determine the profit on the contract. Understanding these values is simple, but can be complicated for those who are not clear with the Options basics.
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