Have you noticed that the value of the options is different to the price of the underlying stock?
The options prices depend on strike price, implied volatility and expiration date. Learn the factors that affect the value of options then buy low and sell high.
How to Calculate the Value of Options?
Trading options is similar to trading other commodities, you buy low and sell high.
But options are tools to hedge against risks, so the price of an option is similar to prices of insurance in that it depends on the value of the options themselves and the probability of assignment.
Options Value = Intrinsic Value + Extrinsic Value
The value of an option is the sum of intrinsic value and extrinsic value:
- The intrinsic value is the profit the option owner gets if the option is assigned right now. If there is no profit to be earned in an assignment, then the intrinsic value is 0.
- The extrinsic value measures the risk of assignment. The extrinsic value is high when the market price is close to the strike price, when IV is high, or when the time to the expiration date is long.
What Are ITM, ATM and OTM?
Depending on different relative positions of market price and options strike price, the options can be ITM, ATM or OTM:
- ITM (In The Money) is when the relative prices of the stock and the strike show a profit if assigned.
- ATM (At The Money) is when the market price equals the strike price.
- OTM (Out of The Money) is when the relative prices of the stock and the strikes show no profit to an assignment.
Let's use SPY ETF as an example. The current price of SPY ETF is $435. From the perspective of Put options, the state is ITM when the Put strike is higher than $435, because there is profit to be had if assigned. So the ITM Put option has both intrinsic and extrinsic values.
When the Put strike is at $435, this is ATM. There is almost no price difference between strike and market prices, so the intrinsic value is almost 0. But the risk of assignment is highest at ATM, so the extrinsic value is at maximum.
When the Put strike is lower than $435, it is OTM. There is no profit to assign OTM options, so the intrinsic value is 0. There is only extrinsic value for OTM options.
From the perspective of Call options, the state is ITM when the Call strike is lower than $435, because there is profit to be had if assigned. So the ITM Call option has both intrinsic and extrinsic values.
When the Call strike is at $435, this is ATM. There is almost no price difference between strike and market prices, so the intrinsic value is almost 0. But the risk of assignment is highest at ATM, so the extrinsic value is at maximum.
When the Call strike is higher than $435, it is OTM. There is no profit to assign OTM options, so the intrinsic value is 0. There is only extrinsic value for OTM options.
How Does IV Affect Options Prices?
Implied Volatility (IV) is the expected movement of the stock price by the market. High IV means the market expects greater price movement to the underlying stocks, so the risk of the option assignment is high, leading to higher extrinsic value.
We can compare two underlying with similar prices to see the impact of IV to options value. SPY and ROKU have similar prices right now, SPY is at $435 while ROKU is around $427. If we look at the IV of the respective stocks within the Options Scanner, SPY's IV is 9% while ROKU's IV is at 46%.
Looking at the OTM Put options at $50 less than the market price that expires next month, we see SPY's $385 Put is worth $1.08, while ROKU's $380 Put is worth $12.85 per contract. So the options' extrinsic value is high when IV is high, and low when IV is low.
Time Value of Options
In theory, the longer Date To Expiration (DTE) is, the higher chances of assignment, leading to higher extrinsic value.
We compare two SPY OTM $385 Put options that expire at different times. The Put option is worth $1.08 at 37 DTE, while it is only worth 9 cents at 7 DTE.
So when all things are equal, the longer the DTE, the more time value the options have, leading to higher extrinsic value.
Now you know the different factors that impact options prices, you can brainstorm different strategies to buy low and sell high to profit from options trading.
Subscribe to our membership to access all the unique stock scanners and receive real-time trade alert emails.
- What Are Options Contracts and How Do They Work?
- Options Wheel Strategy to 3x Your S&P 500 ETF Return
- 3 Things We Hate About Selling Covered Calls
- Complete Guide to the Best Iron Condor Option Entry Points
- How to Buy Apple Stocks at a Discount When AAPL Is Overvalued
- How to Setup Your Telegram Username? Get Real-Time Trade Alerts