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** Premium Evaluation**** **

To trade options successfully, an understanding of the components of the option premium and associated terminology is essential.

**Premium** - is the price paid for the option. It basically consists of two parts, the** Intrinsic Value** and the **Time Value**.

**ATM** (at the money) - an option is ATM if a call or put strike is about the same price as the current price of the underlying stock.

**ITM** (in the money) - a call is ITM if the the call strike price is below the current stock price. A put is ITM if the put strike price is above the current stock price.

**OTM **(out of the money) - a call is OTM if the call strike is above the current stock price. A put is OTM if the put strike is below the current stock price.

**Intrinsic Value** - an option has intrinsic value if it is ITM. The intrinsic value of an ITM option is the difference between the current stock price and the option strike. An ATM option may also have a small amount of intrinsic value. For a call, intrinsic value is the current stock price minus the call strike price (or Stk - Call Strike). For a put, intrinsic value is the put strike price minus the current stock price (or Put Strike - Stk). Once an option goes ITM, the premium should move very closely to penny for penny with the stock price. This is the main advantage of an ITM option. The ITM option provides the benefit of the movement of the stock price for a fraction of the cost of buying the underlying stock outright.

**Time Value** - is the difference between the option premium and the intrinsic value. If the option premium has no intrinsic value, then it consists solely of time value. And although it's called time value, and is largely a function of time, it is a function of many variables. These include - the current underlying stock price and the option strike price (or the difference between the two), the volatility of the stock price, the time to expiration, interest rates and other factors. The further OTM the option is the lower the time premium will be because the chances of the option going ITM are smaller. The more volatile the stock price is the higher the time value premium because the chances of the option going ITM are higher. The more time to expiration the higher the time premium because the chances of the option going ITM are higher. This is the main reason US options are rarely exercised much in advance of the expiration date. The purchaser could buy the stock directly much cheaper than exercising the option.

Where an ITM option's intrinsic value may move penny for penny with the movement of the stock price, an ATM or OTM option's time value moves in a parabolic or exponential relationship. This can be illustrated in the chart above for an actual stock's Call Put curves. The upper dark blue line represents the call asking prices for the various call strike prices. The upper pink line represents the same for the puts. The intersection of the two lines represents the underlying stock's current price. Notice that the angled lower strike premium portion of the call ask line is relatively straight. (The 45 degree angle represents the 1:1 relationship between the stock price movement and the option premium movement.) The call strikes below the current stock price are ITM and reflect the penny for penny movement with the stock price. The portion of the call curve at strikes higher than the current stock price shows an exponentially shaped decay. The call strike prices above the current stock price are OTM and reflect the time value portion of the option premium movement with the stock price. This is similar, but reversed, for the put curve.

So if the height of the two curves above the zero line represents the option premiums at the respective strike price, then the portion above the intersection of the two curves is the intrinsic value. And the portion below is the time value. The chart shows that the time value portion of the premium of the ITM options for this particular stock at the time the chart was created is just over $10. This will vary from stock to stock and from expiration month to expiration month.

Options traders are often interested in what an option premium might be worth given a certain movement in the underlying stock price. As the stock price moves, the Call Put curves will slide horizontally in either direction with the stock price. So for short periods of time, the chart can be used as a graphic to help determine what the options premiums might be based on a particular stock price movement. (Note that this particular chart is for the ticker symbol GS, but any stock that has options can be charted similarly.)

**Volatility** - is the magnitude and frequency of the up and down movement of the underlying stock price. As mentioned above, volatility is one of the variables of the time value portion of an option premium. Volatility in and of itself is volatile, but a snapshot of it can be quantified at a particular time numerically for a particular option from the current stock price and the current option premium. This is referred to as Implied Volatility (IV). The Greeks are also a way to evaluate the movements of options premiums.

**Greeks** - are numerical characteristics of options that cam help to forecast option price movement. These include - Delta, Gamma, Theta and Vega. They're called Greeks because they have Greek names. Delta indicates how much the option premium will move in relation to a movement in the underlying stock price. An ITM option will have a Delta of 1. An OTM option will have a Delta somewhere between zero and 1. Deltas for OTM options constantly change with the underlying stock's price volatility. Gamma is an indication of how much Delta changes with the movement of the underlying stock price. Delta and Gamma can be viewed as the horizontal movement in either direction of the call put chart. Theta is quantifies the Time Value Decay of an option. And Vega is a snapshot of the amount an option premium will change when the volatiltiy of the underlying stock changes. Theta and Vega can be viewed as a vertical displacement in either direction of the call put curves. Many options traders use the Greeks for their options trades, however if a trader understands the variables that make up a premium, the geometry and the dynamics of the premium curve as illustrated in the Call Put curves he will probably have an advantage compared to using the numerical snapshots the Greeks alone.

**Theoretical Option Values - **

**Black Scholes Theory** - is named for the economists who developed it. They received a Nobel prize for developing a theory and a mathematical model (called the Black Scholes Model) to calculate the value of a European style option premium based on the variables mentioned above in the Time Value section. For more detailed information,** this** is a good link. It will also graph the price of the option with movements in stock price. The Call Put charts (used throughout this site), taken from real time options prices, reflect the market value of the otpions. The Black Scholes model, if the variables are entered accurately, can be used to estimate the theoretical value of a specific call or put option at any point between the present and opex day. This could be compared to the real time market prices as a way to determine if the market price is overpriced or not.

**Time Value Decay** - is probably the most important thing to consider and understand before trading options because as time approaches options expiration, the call put chart will move downward toward the zero line. On options expiration day the time value will be zero, therefore, all OTM calls & puts will be worth zero. If the option is ITM, the premium will be approximately the intrinsic value, ie the difference between the strike price and the current stock price, leaving the chart looking like a "V" as illustrated in the call put at opex chart below.

So at expiration, what was once a $10 time value, for this particular ticker symbol, will be zero. This can also be illustrated by looking at charts of the same set of option strikes for several expiration months. So trading options is working against the clock. However, there are option strategies that can minimize time value decay and even put it to work to the trader's advantage.

**Breakeven** - Since the goal is to make a profit, the trader must be interested in the point at which he will start to make a profit or incur a loss. That point is called the breakeven. The breakeven occurs when the stock price has moved enough to cover the cost of the option(s) premium and the commissions. Any movement beyond that point in the trade's favor is profit. Any movement beyond that point against the trade is a loss.

The breakeven point for the purchaser of a call is when the stock price reaches the call strike plus the premium plus the commission for buying the call plus the commission for selling the call. The breakeven for the purchaser of a put is the put strike minus the put premium minus the commission for buying the put minus the commission for selling the put.

When writing a call or a put, there is an immediate profit. Breakeven for a written call occurs if the stock price falls to the the call strike minus the premium and minus the commissions. If it falls below this, a loss starts to accrue. Breakeven for a written put occurs when the stock price reaches the put strike plus the put premium plus commissions. If it goes above this a loss starts to accrue. The maximum profit for written options is achieved when the stock price is at or just slightly below a call strike or at or just slightly above a put strike and the time value has decayed to zero on opex.

**Parity and Disparity**

The charts presented here are based on the asking prices of the options. Actually there are 3 prices listed in options quotes, Last, Bid and Ask. The "last" is the last price the option was traded at. The "bid" is the current highest price buyers are willing to pay for the option. And the "ask" is the current lowest price sellers are willing to sell the option for. A transaction occurs when either the bid ascends to meet the ask or the ask descends to meet the bid or both. It's sort of a instantaneous view of the supply-demand curve. The ask was used in the charts, because it more accurately reflects what would be the current price to purchase the option. The last is a lagging price, especially in low volume options, and doesn't necessarily reflect the current market price.

The difference between the bid and the ask is a spread. There can be spreads between the bid and the ask and spreads between the theoretical value of an option and it's current price. The spread between the value and and the price can also be called a disparity. Throughout the trading day the normal market action can create disparities between the actual value and the current price, but at the end of the day when the market closes the bid and the ask prices should reflect parity with the currently perceived value.

There is also a parity between the call and put prices of the same strike price and expiration month. There is a theoretical mathematical equation that defines the relationship between calls and puts that floor traders use to determine any dispariites and trade if the opportunity presents itself. This can be illustrated by adding the time values of option premiums to the charts as shown below.

Here the time value portions are shown as negative values and therefore are plotted below the zero line. Note again that an ITM option will have a portion of intrinsic value and a portion of time value. OTM options are all time value. If we look at the time value for the call asks at each strike, the lower light blue line, it appears to be the mirror image of the the put ask, the upper pink line. Similarly, the time value of the put asks at each strike, the lower purple line, is the mirror image of the call ask, the upper dark blue line. What this implies is the value of the put is equivalent to the negative time value of the call and the value of a call is the negative time value of the put. If for example, a put is priced higher than the time value of the call or a call is priced higher than the time value of the put, then there is a disparity. At the end of the day when trading is over, the bid and ask prices should be smooth lines and parity should return. During the trading day, however, the lines can get distorted due to the market action.

(Note that the smooth lines only occur when the strike prices are evenly spaced, that is incremented by a constant number. If there is a strike series that is incremented by ones with an offset strike such as 17.5, rather than say 17, it will distort the lines. This is a limitation of the graphing software, not the parity relationship.)

Copyright 2010 OptioNewton. All rights reserved.

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