Options Valuation
Now that you understand how options accounts are opened, this section covers how options are priced. The Series 63 exam explicitly lists options valuation as a testable subject, so you need to be comfortable calculating intrinsic value, time value, and determining moneyness.
Option Premium Components
The option premium (price) consists of two components:
- Intrinsic value - the amount by which the option is in-the-money
- Time value (extrinsic value) - the portion of the premium above intrinsic value, reflecting time to expiration and volatility
Formula: Option Premium = Intrinsic Value + Time Value
Intrinsic Value Calculations
| Option Type | Intrinsic Value Formula | In-the-Money When |
|---|---|---|
| Call | Market Price - Strike Price | Market price is above the strike price |
| Put | Strike Price - Market Price | Market price is below the strike price |
- Intrinsic value can never be negative - if the formula produces a negative number, the intrinsic value is zero (the option is out-of-the-money)
- An option with no intrinsic value has a premium consisting entirely of time value
Exam Tip: Gotchas
- Intrinsic value can never be negative. If your calculation produces a negative number, the intrinsic value is zero and the option is out-of-the-money. The entire premium in that case is time value.
Time Value
- Time value reflects the probability that the option will move into or further into the money before expiration
- Time value is highest when:
- There is more time until expiration
- The underlying asset has greater volatility
- Time value decays as expiration approaches; this is called time decay (or theta)
- At expiration, time value is zero; the option is worth only its intrinsic value (or nothing if out-of-the-money)
Exam Tip: Gotchas
- At expiration, time value is always zero. The option is worth only its intrinsic value. If it has no intrinsic value at expiration, it expires worthless.
Moneyness: In-the-Money, At-the-Money, Out-of-the-Money
| Status | Call Option | Put Option |
|---|---|---|
| In-the-money (ITM) | Market price > Strike price | Market price < Strike price |
| At-the-money (ATM) | Market price = Strike price | Market price = Strike price |
| Out-of-the-money (OTM) | Market price < Strike price | Market price > Strike price |
Memory aid: Calls go up (ITM when market is above strike). Puts go down (ITM when market is below strike).
Exam Tip: Gotchas
- Calls are ITM when the market is ABOVE the strike. Puts are ITM when the market is BELOW the strike. A common trap is reversing these. Remember "Call Up, Put Down."
Worked Examples
Example 1: In-the-money call
- XYZ stock trades at $55. An XYZ 50 Call has a premium of $8.
- Intrinsic value = $55 - $50 = $5
- Time value = $8 - $5 = $3
Example 2: In-the-money put
- XYZ stock trades at $55. An XYZ 60 Put has a premium of $7.
- Intrinsic value = $60 - $55 = $5
- Time value = $7 - $5 = $2
Example 3: Out-of-the-money call
- XYZ stock trades at $55. An XYZ 60 Call has a premium of $2.
- Intrinsic value = $55 - $60 = negative, so intrinsic value = $0
- Time value = $2 - $0 = $2 (the entire premium is time value)