Basic Option Terminology
- Premium - The value of an option and what the buyer pays or the seller receives
- Strike Price - The price at which the underlying product will be exchanged
- Expiry - The date when the option will expire
The same terminology applies to both call and put options.
Vodafone March £1.30 Call priced at £0.15
- The premium of the option is £0.15
- The strike price is £1.30
- The expiry will be the 3rd week of March
Tesco June £3.50 Put priced at £0.45
- The premium of the option is £0.45
- The strike price is £3.50
- The expiry will be the 3rd week of June
Note that all options on UK stocks and stock indexes expire on the 3rd Friday of the month.
How An Option Is Priced
An option is always priced in points or as many refer to them, ticks. The point value is then multiplied by the point size to give the value of the option.
For example UK equity options are multiplied by a fixed £10 per point, so a call option on ICI trading at £0.21 or 21 points is worth £210.
You can also work out the value of an equity option by multiplying the option premium by the number of shares that one option contract represents. We have just seen that an option on UK stocks is on 1,000 shares, so with the same example as above, the ICI option priced at £0.21 is worth £0.21 x 1,000 shares, or £210.
Options on US stock always represent 100 shares, so a Microsoft $25 call priced at $0.50 is worth $0.50 x 100 shares, or $50.
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Stockmarket/Trading Providers
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Option Intrinsic & Time Value
There are always two parts to the pricing of an option: intrinsic value and time value.
Intrinsic Value
- Intrinsic value is the price difference between the underlying security and the option's strike price
- For example, using the BT Jun £1.50 call. If BT stock is at any price above £1.50 the call option has to be worth at least that difference
- Therefore if the stock is trading at £1.76 the option will be priced at a minimum of £0.26
This should be easy to understand because if the option gives the holder the right to buy shares at £1.50 he can then immediately sell the shares in the cash market for a profit of £0.26
The reason why the option may well be worth more than £0.26 is because it has plenty of time value left.
If BT's stock price is £1.50 or lower then the option will have NO intrinsic value. An option must be in-the-money to have an intrinsic value.
Time Value
Time value is the amount by which the premium (price) of an option exceeds its intrinsic value.
If the BT June £1.50 call is trading at £0.45 with the stock at £1.75 then the option will have time value of £0.20 and intrinsic value of £0.25.
- If the BT June £1.80 call is valued at £0.10 with the stock price at £1.70 then there would obviously be no intrinsic value in the options and the £0.10 premium would all be time value
- The longer the option has till expiry the more time value it will have and therefore the higher its price will be
- If BT stock is trading at £2.00, the £2.25 call option with a month to expiry may well be trading at £0.05, but the £2.25 call with nine months till expiry is priced at £0.25
- This is because within one month it's a lot harder for BT to rally over £0.25 than it is over a nine month period
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