Option Values

Russell L. Forkey, Esq., Securities Litigation and FINRA Arbitration Lawyer.

How Option Values are Generally Determined:

The purpose of this post is to provide the reader with general comments on how the value of options is generally determined.  This post is not designed to be complete in all material respects.  This information is being provided for educational purposes only.  Thus, it should not be relied upon as legal or investment advise.  If you have any questions concerning the subject matter of this post, please consult a qualified legal or investment consultant.

The value of options, the amount of their premiums, is mainly determined by the relationship between the exercise price and the market price of the underlying instrument, by the volatility of the underlying instrument and by the time remaining before expiration.

When the relationship between an option's strike price (the exercise price) and the underlying market price is such that the holder would profit (transactions cost aside) by exercising it, an option has intrinsic value and is said to be in the money.  In contrast, there is no intrinsic value in an out of the money option such as a put whose strike price is below the market price or a call whose strike price is above the market price.  A premium will normally trade for at least its intrinsic value, if any.  An out of the  money option, on the other hand, has obviously more risk and a lower premium than an option that is more likely to become profitable.  Options on highly volatile securities and instruments command higher premiums because they are more likely to produce profits when and if they move.

Time value influences premiums because the longer the time remaining, the greater the chance of a favorable movement and the higher the present value of the underlying instrument if exercised.  This time value, also called net premium, decreases as the option approaches its expiration.  For this reason, options are called wasting assets.  The value of an out of the money option is all time value;  that of an in the money option is a combination of time value and intrinsic value.  In general, the greater the potential for gain, the greater the risk of not achieving it.  The father from expiration and the greater the volatility, the higher the premium an option will have.