Stock Options Basics, Part 2
April 13, 2009 – 6:12 amIn this series I’m covering the absolute basics of options. Note that I am not recommending the use of options is any way. I am simply trying to make you aware of how options work to increase your knowledge it the area of investing.
Part 1 of this series covered basic terminology and a couple of examples.
Today I’d like to cover a few more terms and discuss what makes options valuable.
Options are priced using a complex formula, and are based primarily on the following factors
- the current price of the underlying financial instrument (i.e. stock or commodity)
- the amount of time left on the contract
- the strike price of the contract
- the volatility of the underlying financial instrument
- the type of option (i.e. call or put)
- the risk free rate of return
- the dividend rate, if any, on the underlying financial instrument
Most of these should make sense. An option with a strike price that is very close to the current price should be worth more than one with a strike price that is far from the current price. Dividends are cash flow, and options may be worth more if the underlying asset is about to pay a dividend.
Options can be purchased at a variety of strike prices and expiration dates. The further ‘out of the money’ an option is, the less expensive it will be. Of course, it’s also less likely to be ‘in the money’ by the expiration date too.
It’s also important to note that the value of an option has a time portion and an intrinsic value portion. Since the option represents a choice that can be made in the future, the amount of time available on that option has some financial value. Similarly, if an option is already in the money (meaning that for a call the underlying security is already above the strike price) then there is also some intrinsic value. As the option gets closer to the expiration date the time value is reduced but the intrinsic value, if an, remains. The time value diminishes exponentially as the expiration date draws near, which is why some people sell their options before they actually expire.
In the next installment of this series I’ll cover selling calls and puts.
Options are complicated investments and are not for everyone. Additional resources:
- Current options prices can be found at the Chicago Board Of Options Exchange.
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