How are Options Valuated
In this chapter, we will talk about the valuation of options and their premium. Certain terminologies have been used repeatedly in the previous chapters and you will probably be familiar with them. Understanding moneyness, or valuation, will allow you have a solid understanding of the foundations and help you in building your own valuation model when you become a more seasoned trader.
In general, moneyness is affected by 5 factors:
1. Underlying Asset.
2. Expiration Date.
3. Strike Price.
5. The Premium, or the cost of the contract.
In many financial literatures, moneyness is sometimes also known as a way to describe the intrinsic value of an option.
The intrinsic value of an option simply refers to the market price of the underlying asset of an option minus the strike price. For example, ChocoMart in June is worth $20. You have a call option of September 15 call (note the naming convention: Date, Strike Price and Class) that is worth $7. The intrinsic value of your stock is therefore $20-$15=$5. The time value of your option premium is $7-$5 = $2. (Premium = Intrinsic Value + Time Value).
Take a minute to digest this, and read over again if needed before reading on.
There are three terminologies we use to describe the moneyness of an option:
1. In-the-Money – This means that the option has a positive intrinsic value. If you look at the example above, it actually makes more sense to close the option for a $7 profit rather than exercising the option and sell the shares for a $5 profit.
2. Out-of-the-Money – Intuitively, this would mean that the intrinsic value of the options is negative. Recall that intrinsic value is market price minus strike price. However, the value is never truly negative because zero is the lowest value.
3. At-the-Money – If the share price tied to the contract remains the same, we say that the options is at the money and that exercising the option will not result in any profit. In fact, it is still a loss due to the cost of commissions. Note that even if the intrinsic value of the option is zero, it still has a positive time value attached to it.
So, by now you might be asking: What is the purpose of the time value?
Well, it turns out that the time value is what is stopping people from exercising their options! If you refer to the example that we have talked about above, you can see that the difference in profit between exercising the option and closing the position is the time value!
The larger the time value, the more it makes sense to close a position rather than exercising the option.
The actual mechanics of how time value is established is again, a complex mathematical model. If you are interested in finding out more, you might want to read up on the Black-Scholes option pricing model.
Overall, besides understanding the mathematics behind this, options valuation also takes experience to be perfected. One of the key ways you can improve is by getting hands on experience by trading virtual options!