US options trading is a flexible financial product, giving traders and investors opportunities to manage risk, speculate on market movements, and increase returns. These derivatives provide flexibility through calls and put, creating strategic participation in the financial markets even without asset ownership. The premium in options trading is important to understand the price paid for the right to buy or sell an inherent asset. In it, the premium is composed of two key components: intrinsic value and time value.
The premium in options trading
The option's premium is the sum of the intrinsic and time values:
Option Premium = Intrinsic Value + Time Value
The premium for in-the-money (or intrinsically valuable) option reading consists of both parts. Time value is the only component of out-of-the-money options or those without inherent value. For traders using option techniques like selling weekly options, where time decay is crucial to producing steady money, it is imperative to comprehend this relationship.
Understanding intrinsic value and time value
1. Definition
Intrinsic value is the actual, tangible value of options trading at any given moment. It represents the difference between the price of the underlying asset at the current time and the strike price of the option. If exercising the option is immediately profitable, the option has intrinsic value; otherwise, the intrinsic value is zero.
On the other hand, time value is the extra value an option's premium has because there is still time left for the stock price to move in a favorable direction. The longer time available, the higher the time value. It is available for all options trading if there is enough time remaining before expiration. The moment the option expires, the time value becomes zero.
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2. Calculation
Intrinsic value
- Call Option: Intrinsic Value = Current Market Price - Strike Price (if positive, otherwise 0)
- Put Option: Intrinsic Value = Strike Price - Current Market Price (if positive, otherwise 0)
Time value
In contrast to intrinsic value, time value deteriorates over time, provided all other factors, like the underlying asset's price and market volatility, remain constant. This is referred to as “theta decay," quantified in pricing models like Black-Scholes. It’s typically a negative number indicating a daily loss in value. The time value eventually goes zero upon expiry as a result of this decay, which quickens as the date draws near.
Here are some factors affecting time value on options trading:
- Time to Expiration: Longer durations result in higher time values.
- Volatility: Greater market volatility increases the likelihood of price movement, boosting time value.
- Interest Rates and Dividends: These can also influence time value.
Examples to calculate the intrinsic value and time value
1. In call option
Let's consider a call option with a strike price of $100, and the market price of a certain stock is $105 now. Assume the option is trading at a premium of $7.
Intrinsic value calculation: Intrinsic Value= max (Current Price – Strike Price) =(105−100,0)=5
Time value calculation: Option Premium – Intrinsic Value=7-5=2
This means that if you were to exercise the option now, you would be able to buy shares of a certain stock at $100 and sell them at the current market price of $105, effectively gaining $5 per share on this options trading.
2. In put option
Assume that a put option is with a strike price of $60 while the current market price of the stock is $55. Assume the option is trading at a premium of $8.
Intrinsic value calculation: Intrinsic Value= max (Strike Price – Current Price) =(105−100,0)=5
Time value calculation: Option Premium – Intrinsic Value=8-5=3
The put option has an intrinsic value of $5 (it would be profitable by $5 per share if exercised immediately) and an extrinsic value of $3, which includes the value of time and expected volatility until expiration.
Summary
Options trading involves understanding key concepts such as intrinsic value and time value, which are crucial for strategic decision-making. Tiger Trade is an options trading platform that offers a range of tools designed to assist in monitoring market dynamics, including large block trades.
Tiger Trade supports various options strategies, offers competitive pricing on trading fees, and enables the placement of multi-leg options orders. Visit Tiger Brokers' official website to learn more about knowledge of options trading!
Disclaimer:
The information expressed herein is current and does not constitute an offer, recommendation or solicitation, nor does it constitute any prediction of likely future performance. Investment involves risk. The price of investment instruments can and do fluctuate, and any individual instrument may experience upward or downward movements, and under certain circumstances may even become valueless. Past performance is not a guarantee of future results. In preparing this information, we did not take into account the investment objectives, financial situation or particular needs of any person or affiliated companies. Please read the disclosure statements and terms on our website and consider whether obtaining or continuing to hold financial products is suitable for you before opening an account or making investment decisions. Before making an investment decision, you should speak to a financial adviser to consider whether this information is appropriate to your needs, objectives and circumstances. Tiger Brokers (Singapore) Pte. Ltd. assumes no fiduciary responsibility or liability for any financial consequences or otherwise arising from trading in investment instruments if opinions and information in this document may be relied upon. This advertisement has not been reviewed by the Monetary Authority of Singapore. Tiger Brokers (Singapore) Pte. Ltd. (Reg. No. 201810449W).