The Unlucky Investor's Guide to Options Trading guides readers through the world of options and teaches the crucial risk management techniques for sustainable investing.
Where an option gets its price can seem like smoke and mirrors when first learning about option trading, but it is actually pretty simple. Option value, also known as option premium, is really just made up of two contributing factors - intrinsic & extrinsic value. These values change based on three inputs: strike price in relation to the stock price, implied volatility, and time until expiration. That’s it! We won’t leave you there though - let’s dive a little deeper and start with intrinsic value.
Intrinsic Value - Call Option
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 100 shares at a certain strike, these options have intrinsic value if they are above the stock price.
If the stock price is at $50, and we own a put option with a strike at 56, the put option has intrinsic value. We have the right to sell 100 shares at $56, even when the stock price is at $50. The intrinsic value calculation is the same - it is just the difference between our ITM strike and the stock price. This put option would have $6.00 of intrinsic value per share (56 - 50 = 6).
Just like calls, if a put option is OTM it has no intrinsic value. If we owned that 56 put and the stock price was at $60, the put would have no intrinsic value. We would have the right to sell shares at $56, but we could sell the shares at $60 in the market. 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? Because there is still time and implied volatility of the underlying. This is known as extrinsic value.
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