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Value of Options
Since options are risky investments and have a cost attached to them in the form of a premium, it is important to know their value before purchasing them. An option's price is made up of two components; the intrinsic value and the time value. The intrinsic value of an option is the amount that the option is in-the-money. The intrinsic value of a call option for a share with strike price of $50 and current market price of $55 is $5. It reflects the profit that can be earned if the option was exercised immediately. The intrinsic value of an option can never be zero as the option holder will choose not to exercise an out-of-money option. Time value is the premium that the option holder has to pay for the potential upside of the share price until expiry. Options are also called ‘wasting assets’ and the time value will keep reducing as the expiration date draws closer. The time value on the expiration day is zero. Hence, at expiry the value of option is simply its intrinsic value. After understanding the components of an option's price, valuing the option is a simple present value problem. Let’s start with the simplest situation. Suppose an investor predicts that the price of a stock will reach $60 in six months and purchases a call option with a strike price of $50. If the market price moves as expected and reaches $60 in six months, the investor will exercise the option to buy the stock for $50 and then immediately sell it in the market for $60, thus earning a profit of $10. In another words, the call option has a value of $10 in six months. For finding out the fair value of this option today, we simply need to discount the future cash flow ($10) back to today. Assuming the expected annual rate of return is 7%, the present value of the option will be $9.66 ( $10/ (1+0.07/2). As the market price of the underlying shares keeps changing throughout the life time of the option, the fair value of the option will also keep changing. The advantage of options is that you aren't limited to making a profit only when the market goes up. Because of the versatility of options, you can also make money when the market goes down or even sideways by using different options simultaneously. While options provide the means for betting against a stock, they are inherently a very risky investment with the entire investment to lose if the stock price does not move as anticipated. Moreover, making accurate predictions on the market direction is not sufficient. It is equally important to predict the timing and magnitude of the movement. Many companies have incurred significant financial losses by taking huge positions in options without being aware of the limitations and cost factor, premium, attached to options. Despite these shortcomings, overall, options can offer a sophisticated investor a good opportunity to formulate plans which can take advantage of the volatility in underlying markets as well as price direction.