Option Valuation 101

Topic: Option Valuation 101

Note: My replies to points as they arise are in brackets [ ].

Dear Options Trading FAQ:

I'm a big time options trader. Please correct me if I'm wrong: [With a question this long, I don’t care how wrong you are - you definitely get partial credit!]

I understand that options have (at least) three contributing factors to their current price:
- intrinsic value
- time premium
- volatility premium

[What about fine tuning with riskless rate of return, historical volatility, etc.? See the Black Scholes Formula for options valuation.]

1. Option price = Intrinsic value + time premium + volatility premium, but cannot be negative.

[On a general basis, the above factors do contribute to the current price of an option but see the classic option valuation model for the mathematical formula]

2. Intrinsic value of an option can be positive or negative. It changes with time, and is the difference between the strike price and the current value of the underlying stock or index.

[An option is either worth something intrinsically or not, there is no penalty (negative value) for being out-of-the-money. So intrinsic value is a positive value or zero. Other wise an option can be worth less than zero. Maybe a money penalty like that would keep me out of my more stupid option purchases!]

3. The time premium of an option can be positive or zero, but not negative. It decreases from being most positive at the start down to zero at expiration.

[Time waits for no one...(Mick Jagger)]

4. The volatility premium of an option can be positive or zero, but not negative. It is greater with greater volatility in the underlying stock or index, and is smaller with smaller volatility in the underlying stock or index.

[The volatility factor in the Black Scholes Option Valuation Model is the trickiest part. A historical figure is usually assigned. This assumption does not account for up-to-the-minute jumps. Hence the pros use the current trading price to back out a value for volatility through the Black Scholes. This is the famous Implied Volatility reading. Watch for sudden jumps in the i.v.]

Assuming that the above statements are correct (and we all know what happens when you ass-u-me ), I have the following questions for you:

1. How does the time premium vary as one gets closer to the option expiration date? Is it linear or (as I'm guessing) some other shape? Does it look something like the below graph, which starts out flat, but decreases sharply as the expiration date approaches?

^ Time ----------------\ Premium --------\ ----\ --\ -\ \ +-----------------------------------------> Time ^ Expiration Date

[above chart may get wacked out by e-mailing]

[Good approximation. Option premium sellers look to ride down the premium during that area towards the end when decay is most drastic.]

2. Which has more effect on the ultimate price of an option, the time premium or the volatility premium? If the graph above is at all correct, it would seem that when option expiration is far off (in time), the time premium would be the over-riding effect. But as you get closer to expiration, and the time premium decreases, the volatility premium could become an increasing factor to the point that it's effect over-rides that of the time premium. What are typical values for time and volatility premiums on the options?

[Here is a drastic example of what the volatility factor can do for the option premium: In the aftermath of the Crash of 87, call options on the OEX 60 points out of the money still were trading over $1. The swell in volatility was so great that it accounted for most of the option’s premium. See the option valuation model for the math relationships. In a more normal setting, volatility doesn’t usually spike up to make up for steady loss in time value. If you are an option buyer, volatility is your friend and if you are an option seller, time decay is your favorite companion.]

3. What happens to the price of an option who's intrinsic value is so negative (i.e. it is so out of the money) that no time premium or volatility premium could ever make up for it? Obviously, the price can't be negative. Is it just never sold, and the holder is forced to keep it until it either becomes in the money, or expires worthless?

[There are no restrictions on such an option. It can always be sold for a loss unless there is no bid. This situation is not at all uncommon. As a matter of fact, most options expire worthless. The option wars exact many casualties.]

I appreciate any response that you can give me. I realize that these can be categorized as "beginner" questions, but I am trying to learn all that I can before entering the options market. In addition, I am trying to make an overall options pricing model that disregards the volatility (over the short-term).

[You must do some reading on theoretical option valuation. Warning: Do not ignore volatility. It is the most crucial component of option valuation. The key to using options to forecast upcoming stock moves is to watch for unexplained jumps in implied volatility!]

Thanks in advance, Just Beginning Options Trading

Dear Option Beginner:

Wow! I’d hate to see the questions you send after you bone up on the option textbook theory. (If you start asking about the Greeks - i.e. delta, vega, gamma, I’m quitting!)

Seriously, read McMillan’s Options as a Strategic Investment as well as the educational materials from the option exchanges.

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Theory, Options Pricing, Options Valuation

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