Options Review, Pt 2 - Fundamentals

[Options Review Series 1 - 2 - 3 - 4 - 5]

Next let's look at Options. They are instruments which give you the flexibility ("option") to undertake an action if you feel it is beneficial.

The value of options are composed of two components, the intrinsic value and the time value.

Intrinsic value is the easiest to understand. It is the difference in value between the excise price and the current market price. If you option allows you to execute the option at price X, and the market price for the underlying asset is St, there is a intrinsic profit / loss potential of (St-X) and profit or loss would depend on which side of the transaction you are on (long or short). More on this later. Options have special words for profit or loss based on the intrinsic value. If the holder of an option (the Long position) earns a profit based on the current position of the option (St - X), the option is said to be "in-the-money". If the opposite is true, the option is said to be "out-of-the-money".

Regarding time value of options, there are generally two types of options. American and European. Here are some key points:

• American options can be exercised at anytime.
  
• European stocks can only be exercised at expiration.
  
• The flexibility of American style options makes them more attractive and therefore equal to or more valuable under every circumstance than their European counterparts. This is a tip for removing incorrect answers in the CFA exam.
  
• The time value of an option is always greater than zero.
• Time value of an option increases as the stock volatility increases (options are protection against volatility)
  

Option Value = Intrinsic Value + Time Value

Note that even if Intrinsic Value drops to zero, the Time Value must always be positive therefore the Option Value must always be positive. If by expiration, an option is not used, it expires and becomes worthless. The lowest possible price allowable for an option is 0. It cannot become negative.

While options sound fantastic (they always have positive value) don't forget that an upfront premium is needed to purchase the option. As we will see in the next post, this creates more balanced (and realistic) scenarios for profit and loss.

[Options Review Series 1 - 2 - 3 - 4 - 5]