| |
| |
|
|
Investing Information |
|
Fundamentals of Option Pricing
When one begins to consider an option, it is very important to figure out how the premium is calculated. Option premiums depend on a variety of factors including the time left to expiry as well as the price of the underlying security. There are two parts to an option premium: intrinsic value and time value. Consequently, several different factors have an influence on intrinsic and time value. Intrinsic Value Intrinsic value is the difference between the market price of the underlying shares at any given moment in time and the exercise price of the option. The following are a couple of examples for call and put options. Call Options For example, say MicroCeuticals (MC) April $25.00 call options are trading at a premium of $6.00 and MC shares are trading at $30.00 per share, the option has $5.00 intrinsic value. The latter is true because the option taker has the right to purchase the shares for $25.00, which is $5.00 lower than the market price. Such options, which have intrinsic value, are said to be 'in-the-money'. In this example, the remaining $1.00 of the premium is time value ($6.00 - $5.00). If the shares of MC were trading at $23.00, intrinsic value would effectively be zero because the $25.00 call option contract would only enable the taker to purchase the shares for $25.00 per share, which is $2.00 higher than the market price. When the share price is less than the exercise price of the call option, the option is considered to be 'out-of-the-money'. It is important to remember that call options convey to the taker the right, but NOT the obligation to purchase the underlying shares. If the share price is below the exercise price, then it is probably better to purchase the shares on the share market and let the options lapse. Put Options Put options work in the opposite way to calls. If the exercise price is greater than the market price of the share, then the put option is in-the-money and possesses intrinsic value. Exercising the in-the-money put option allows the taker to sell the shares for a higher price than the current market price. For example, an MC April $40.00 put option allows the holder to sell MC shares for $40.00 when the current market price for MC is $35.00. This option has a premium of $5.50, which consists of $5.00 of intrinsic value and 50 cents time value. A put option is out-of-the-money when the share price is above the exercise price, since a taker will not exercise the put to sell the shares below the current share price. As you may recall, put options convey the right, but not the obligation to sell the underlying shares. If the share price is above the exercise price then it is probably better to sell the shares on the share market and let the option lapse. It should be noted that when the share price equals the market price, the call and put options are said to be 'at-the-money'. Time Value Time value represents the amount that you are prepared to pay for the possibility that the market might move in your favor throughout the life of the option. It represents and extra payment to the writer of the option to offset the risk that the underlying share will move, and result in a loss to the writer. Time value will vary with in-the-money, at-the-money, and out-of-the-money options and is greatest for at-the-money options. As the time of expiry draws near and the opportunities for the option to become profitable decline, the time value decreases. This dilution of option value is termed time decay. Time value does not decay at a constant rate, but becomes more rapid, possibly even exponential, as one gets closer to expiry. Time value is influenced by the following factors, among others: time to expiry, interest rates, market volatility (which you can quantify using Bollinger Bands), dividend payments, and market expectations. The time value of an option is greater the longer the time to expiry. The premium will be higher under conditions of high market volatility. Again, Bollinger Bands are a great way to measure market volatility. This is a consequence of the wider range over which the stock or commodity can potentially move. As interest rates increase, call option premiums will be driven up, while put option premiums will be pushed down. Supply and demand will determine the market value of all options. During times of strong demand, premiums will undoubtedly be higher. Hopefully this article will provide investors and traders considering purchasing or selling options with more information. Although technical analysis is useful in attempting to predict market movement, fundamental analysis of options via the use of the factors described above may provide many traders with benefits as well. Joshua M. Kunken is Chief Currency Analyst for ForeignMarketWatch.com. His articles have also been featured at ForexTrack.
MORE RESOURCES:
Investing - Google News |
|
|
|
RELATED ARTICLES
Short Term Savings Products When you invest, it simply means that you are putting your funds in products, in this case short-term savings vehicles, which will allow you to reap high financial rewards.Here is a list of the more common short term savings products you should consider investing in. Buying Florida Investment Properties and Where Its Hot Relaxing in Style: Florida Investment PropertiesIn Florida, relaxing in the sun and sand is a way of life. There's no better way to experience a slice of Florida living than buying your own space. The Basics of Tax-Free UK Financial Spread Betting Financial Spread Betting (or Trading) offers a tax free method of speculating on financial markets.Quite simply, if you think a particular index, share, commodity, currency or sector will rise, you place an UP bet. Making Every Penny Count More and more workers are leaving their jobs and taking their 401 k retirement plan funds with them. While some are rolling their funds over into IRAs or other qualified plans; many are taking their distributions in cash. The Myth of the Earnings Yield AbstractA very slim minority of firms distribute dividends. This truism has revolutionary implications. Why the Rich Keep Getting Richer Rich people: fortunate, lucky, selfish, and arrogant? Or highly educated, caring, brilliant individuals? Becoming rich isn't hard, but it does require a bit of time and knowledge. Having time to get rich, educating oneself, and buying assets are the three key factors in attaining untold wealth. Gold; What Type of Gold to Buy JewelryThe advantages are:? Gold Jewelry is the easiest of the gold to buy and has the enjoyment of being able to be worn.The disadvantages are:? Retail Jewelry is often marked up by 300% or more in the shops. Short Selling for Investors Shorts. Let's see. Chinas Great Missed Opportunity While a U.S. The Conflict of Interest Game Disgruntled investors are going after Wall Street once again, this time accusing one of investment bank Morgan-Stanley's high-tech mutual funds of making biased stock picks.Recent lawsuits allege the Morgan Stanley Technology fund was influenced to buy and hold stocks of companies that delivered huge investment banking fees - or could potentially bring big business - to the investment bank. Are You An Investment Dummy Like Me? I am good at a few things. I can certainly market well and I consult with others about how to bring more attention to their products and services on the internet for a living. Should You Put Your Annuity in an IRA? Let me start by answering that question.. Numismatics are for Collectors, Not Investors As a precious metals investor, you may heard much about numismatic and "semi-numismatic" coins, particularly the St. Gaudens $20 double eagle gold coin. A Safe Port For Mutual Funds But Not You! Soft dollars, a form of legal kickback, is a sly way you can get ripped off by mutual fund managers. Full service brokers give these kickbacks to non-indexed mutual funds in the form of a "rebate" to purchase research, software, and even computer equipment. Trading Expert Discovers Ways To Beat Stock Market Odds With Money Management The first point to mastering money management is that you have to understand when you're trading on the stock market is that you are playing the odds - but unlike many forms of gambling, you can make money. The key to making this money is to respect the risk that is part of the market, and manage it. Trading Commodity Futures Using Support and Resistance - Paper Trading Setting Up a Paper Trading AccountQuestion: I cannot trade with "real money" as yet; however, how do I go about setting up a paper trade account?Answer: You can paper trade various ways and it really does not require that you have anything more specialized than a notebook to track your trades and access to charts.Begin by funding your paper trading account with the amount of money you think you will really begin with, whether it is $2000 or $20,000. The 8 Biggest Mistakes When Designing Portfolios - and How To Avoid Them Are you as good an investor as you think? Do you consider yourself a well-informed investor able to anticipate and avoid nearly all pitfalls associated with investing? Chances are, you are making one of the common errors that could cost you hundreds or even thousands of dollars, or worse yet, your financial independence, control and security."I see people making the same costly mistakes over and over," says Scott Frush, CERTIFIED FINANCIAL PLANNER and author of Optimal Investing: How To Protect and Grow Your Wealth With Asset Allocation (Marshall Rand Publishing; available by calling 1-800-247-6553). Just Say NO to Your Stock Broker We have all heard that slogan that started back when Nancy Reagan was in Washington. It was all about drugs. Annuity Investment Guide While there is not a lack of information on annuities, there certainly is a lack of good information. In an age full of information, we are constantly bombarded with irrelevant data. Investing & Online Stock & Share Trading: Money & Risk Management - Atkinson Portfolio Planner (1) This article was originally featured in Daryl Guppy's 'Tutorials in Applied Technical Analysis', voted no 1 trading newsletter in Australia by Shares magazine & no 4 in the world by US Stocks & Commodities magazine and is reprinted here with Daryl's permission.In addition to developing sound technical analysis skills, strong trading psychology coupled with well thought-out money and risk management are also vital key secrets for success when trading or investing in the market.
|
||||||||||||||||
