The Latest MarketVision Chronicle has a piece about the Pricing of Options:
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There are two parts to an option – the intrinsic value and the time value. If a call option’s strike price is below the current market price, the option will have some intrinsic value – that is, the difference between the strike price and the market price. Oh, too much theory. Let’s do an example:
For puts, you get positive intrinsic values only for strikes ABOVE the current market price. These are called in-the-money (ITM) options. Other options are called “out-of-the-money” (OTM) options – the 6100 call or the 6000 put in the example above have no time value, and are OTM.
Intrinsic value is easy: all you need is a mathematical difference. The time value is simply this: If I asked you to buy a share at a fixed price today, but I’ll only give you the share in a month, how much more would you pay me?
The answer lies in multiple pieces:
Time to expiry: The amount of time left on the contract is a determinator – and all other things remaining constant, the time value comes down as you approach expiry:
The volatility of the stock: If a stock goes up 10% in one month and down 15% the next you would think of it has highly volatile. The more volatile you expect the stock to be, the higher “premium” you will demand for a fixed price contract – and therefore a higher option price.
There are two ways to look at volatility. When you take a look at how volatile the stock has been recently, and use that as a parameter to price the option. But that has little value since the past movement doesn’t always follow the future. For instance, would you say that a stock has moved just 1% a month for the last three months, and price an option low, when it has results coming out tomorrow?Historical volatility is useful theoretically but is not very practical.