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.
Now, tell them about it: