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How the difference between stock’s price and the strike price can make you money

The potential difference between the stock’s price and option’s strike price is what makes options unique and gives them their value. This page explains and demonstrates how it works.


At a glance

Explaining the unique characteristics of options and how that translates to potential value for an investor.


Understanding Options Pricing
The specific stock on which an option contract is based is commonly referred to as the underlying security. Options are categorized as derivative securities because their value is derived in part from the value and characteristics of the underlying security. A stock option contract’s unit of trade is the number of shares of underlying stock which are represented by that option. Generally speaking, stock options have a unit of trade of 100 shares. This means that one option contract represents the right to buy or sell 100 shares of the underlying security.

Strike Price
The strike price, or exercise price, of an option is the specified share price at which the shares of stock can be bought or sold by the holder, or buyer, of the option contract if they exercise their right against a writer, or seller, of the option. To exercise your option is to exercise your right to buy (in the case of a call) or sell (in the case of a put) the underlying shares at the specified strike price of the option.

The strike price, a fixed specification of an option contract, should not be confused with the premium, the price at which the contract trades on the market, which fluctuates based on market conditions.

In-the-money
If the strike price of a call option is less than the current market price of the underlying security, the call is said to be in-the-money because the holder of this call has the right to buy the stock at a price which is less than the price that would have to be paid to buy the stock in the stock market.

Out-of-the-money
If a put option has a strike price that is greater than the current market price of the underlying security, it is also said to be in-the-money because the holder of this put has the right to sell the stock at a price which is greater than the price that would be received for selling the stock in the stock market.

Out-of-the-money and at-the-money
The converse of in-the-money is, not surprisingly, out-of-the-money. If the strike price equals the current market price, the option is said to be at the-money.

Premium
Option buyers pay a price for the right to buy or sell the underlying security. This price is called the option premium. The premium is paid to the writer, or seller, of the option. In return, the writer of a call option is obligated to deliver the underlying security (in return for the strike price per share) to an option buyer if the call is exercised and, likewise, the writer of a put option is obligated to take delivery of the underlying security (at a cost of the strike price per share) from an option buyer if the put is exercised. Whether or not an option is ever exercised, the writer keeps the premium. Premiums are quoted on a per share basis. Thus, a premium of $1.00 represents a premium payment of $100.00 per option contract ($1.00 x 100 shares).

Underlying Stock Price
The value of an option depends heavily upon the price of its underlying stock. If the price of the stock is above a call option’s strike price, the call option is said to be in-the-money. Likewise, if the stock price is below a put option’s strike price, the put option is in-the-money. The difference between an in-the-money option’s strike price and the current market price of a share of its underlying security is referred to as the option’s intrinsic value.

Only in-the-money options have intrinsic value. For example, if a call option’s strike price is $45 and the underlying shares are trading at $60, the option has intrinsic value of $ 15 because the holder of that option could exercise the option and buy the shares at $45. The buyer could then immediately sell these shares on the stock market for $60, yielding a profit of $ 15 per share, or $ 1,500 per option contract

When the underlying share price is equal to the strike price, the option (either call or put) is at-the-money. An option which is not in-the-money or at-the-money is said to be out-of-the-money. An at-the-money or out-of-the-money option has no intrinsic value, but this does not mean it can be obtained at no cost.

Time Value
The primary components of time value are time remaining until expiration, volatility, dividends, and interest rates. Time value is the amount by which the option premium exceeds the intrinsic value.

Option Premium = Intrinsic Value + Time Value
For in-the-money options, the time value is the excess portion over intrinsic value. For at-the-money and out-of-the-money options, the time value is the option premium.

Time Remaining Until Expiration
Generally, the longer the time remaining until an option’s expiration date, the higher the option premium because there is a greater possibility that the underlying share price might move so as to make the option in-the-money. Time value drops rapidly in the last several weeks of an option’s life.

Volatility
Volatility is the propensity of the underlying security’s market price to fluctuate either up or down. Therefore, volatility of the underlying share price influences the option premium. The higher the volatility of the stock, the higher the premium because there is, again, a greater possibility that the option will move in-the-money.

Dividends
Regular cash dividends are paid to the stock owner. Therefore, cash dividends affect option premiums through their effect on the underlying share price. Because the stock price is expected to fall by the amount of the cash dividend, higher cash dividends tend to imply lower call premiums and higher put premiums. Options customarily reflect the influences of stock dividends (e.g., additional shares of stock) and stock splits because the number of shares represented by each option is adjusted to take these changes into consideration.

Interest Rates
Historically, higher interest rates have tended to result in higher call premiums and lower put premiums.

Source: www.scotiabank.com/itrade/en/0,,3981,00.html

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