Sheridan Options Mentoring Blog |  |
| Posted: 30 Sep 2011 06:09 AM PDT Options can be confusing. The world with which an options trader deals is described by a host of confusing and often redundant terms. The extremely dynamic nature of options and option based trades produces additional confusion as, for example, a particular individual option moves from out-of-the-money to at-the-money to in-the-money within the course of a few hours or even minutes. I think it is helpful to have a thorough understanding of the anatomy of an option premium in order to help provide an organizational framework. Once the trader understands the basic anatomy with which he is dealing, the behavior of the options begins to make more sense. The price of an option premium is quoted as a bid and ask price. The magnitude of the difference between these two prices can be quite variable. As a general rule, the more active the option series, the tighter the bid-ask spread. The actual price at which the option trades is usually somewhere between these two quotes. However another important variable is the recognition that this negotiated price at which an option trades is actually the sum of two components which have very different behaviors. This price is composed of the sum of the intrinsic and extrinsic (also known as time premium) values of the option. Given the particular option strike price and expiration month, the embedded intrinsic value can range from $0 to almost the entirety of the value of the option. Similarly, the extrinsic value can range from the entirety of the premium to only a small portion of the entire premium. Consider the recent AAPL October monthly series option quote montage displayed below. This table represents a snapshot of option prices at an instant in time when AAPL traded at $396.92.
The market price of the option at this particular point in time is displayed in the boxed column headed "Mid" and the extrinsic (time) component is highlight in the column indicated by the ovoid. The intrinsic value represents the embedded value directly attributable to the current market price of the underlying. This value can easily be calculated by subtracting the extrinsic value from the total market price of the option. The intrinsic value of the option will reliably track penny for penny with the price of the underlying. One potential point of confusion deals with the at-the-money strike option. Rarely is the price of an underlying at precisely the strike price of an available option. There is always an at-the-money strike, and it is defined as the option with the strike price closest to the current market price. In our example of AAPL, this would be the $395 strike; note that this strike price is highlighted in red in the quote box. A few minutes study of this quote board reveals several important and consistent functional characteristics of options pricing. These include:
It is important to consider the amount of time premium contained within the option price because this represents value that is reliably and constantly eroded by the passage of time. In addition, it is only this extrinsic component that is impacted by the variation in implied volatility. In contrast, the intrinsic premium rises and falls as a result of only changes in the market price of the underlying. While this discussion may seem a bit theoretical, understanding of these concepts is critically important to structuring option positions as well as understanding their response to market conditions and the impact of the passage of time on positions. Familiarity with these concepts allows trades to be constructed with a higher probability of success. For example, a basic vertical call debit spread can often be constructed by buying an in-the-money option, and selling an out-of-the-money option containing more time premium than you have bought. In such cases, you are able to "sell sizzle and buy steak". |
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