Saturday, August 24th, 2019

What is an Option Worth?

November 24, 2009 by T.D. Thompson  
Filed under Options Trading Tips

 

The basis of options trading is to know what an option is worth. In basic terms we want to know if the difference between the strike price and the spot price will grow and in which direction. The strike price is the agreed up price that the contract will be settled for if the option is exercised and the spot price is the market price. Things as basic as upcoming dividends are added to the price of an option until the day that dividends are paid. The rest of option value has to do with the market’s consensus of what the stock will be worth in the future.

For someone buying a put to protect a stock position in a very volatile market the option value is its insurance value as the individual only intends to exercise the put option if the spot price drops below the strike price. Similarly for someone selling a call option the option value is the premium as the selling cannot profit from a divergence of the spot price from the strike price.

Option value is different for the buyer of a call option. Here the buyer stands to make a lot of money if the spot price goes far above the strike price. The option value will, in fact, go up as the spot price goes up. Thus the option becomes more expensive to buy. As options are traded during the term of their contract an options trader need never buy or sell stock, only trade the option. For the buyer of a call option the option value can be a multiple of the premium paid if the spot price rises substantially over the strike price. The only risk for the buyer of an option is that there is no option value if the spot price does not rise above the strike price.

Generally option value is based upon the following:

  • The day’s market price of the security in question
  • The strike price of the option (in relation to the spot price
  • Costs and profits involved in holding a position in an underlying security
  • Time to expiration of the options contract
  • The market estimate of what the spot price will be at the end of the contract and how much the stock will fluctuate from now to then

The ideal situation when buying a call option is that the option value is low at the beginning of the contract and as the spot price fluctuates and, hopefully, goes up the option value goes up with the spot price. When the market decides that a stock’s spot price is likely to go up or down dramatically is when the option value moves (up or down) dramatically. This is one place where fortunes are made in options trading. An payment of a premium of two to four dollars a share for a 100 share block of stock can turn into tens of dollars a share if the spot price rises substantially above the strike price.

If you bought stock at $50 a share and the spot price goes to $100 a share you are a happy investor with a 100% profit to brag about at the office. If you paid $2 a share for a call option on the same stock you will make a 25 fold or 2500% profit. In that case the option value will be such that you may be sailing your yacht around the world and no longer in the office.

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