You have done your homework on a stock, analyzing its fundamental and technical data, and you are bullish about its potential over the next few months. You decide to buy call options to make the most of your forecast. Over the next few weeks, the stock climbs slightly, and you see the value of your call options declining instead of rising. What is going on? The stock’s price is going up, but your call options are worth less. There has to be some kind of mistake here! This would be true if options’ prices were only correlated with the underlying stock’s price, but they are not.
In this article, we break down the price of an option according to its variables and examine the impact of each variable on its value.
Premium of an option = Intrinsic value + time value
An option’s price is comprised of two variables: intrinsic value and time value. Intrinsic value is that part of the option’s premium related to the difference between the stock’s price and the strike on the option. In our example, since the price of the stock has increased, it is likely that the intrinsic value of our option has also increased. For a call option, the intrinsic value is the difference between the price of the stock and the strike, as long as the stock is trading at a price that is higher than the strike. In cases where the stock price is below the strike price, the intrinsic value of the option is zero. This is because if the stock is trading below the strike when the option expires, then the holder of the call option will not exercise his right to buy the stock, since shares can be bought directly on the market for less than the strike price. In this case, the option will be worthless on expiration.
So if the intrinsic value of your call option has increased and its total premium has decreased, this can only mean that the time value of the option has fallen by more than the entire gain in intrinsic value. Is this really possible? Yes, absolutely!
Value on expiration – option premium = Intrinsic value
The time value of an option, as the name suggests, is related to the time remaining until the option’s expiration. So as each day passes, part of the option’s value goes up in smoke. If there is one thing we can count on, it is that when an option expires, its time value is zero, so its premium will be equal to its intrinsic value.
So when you write call options because you expect the price of the stock to go up, you need to be aware that the price of the stock has to rise by at least the time value of the option before you can begin to make a profit. This is the challenge we all face when we use options to achieve our investment goals.
Since it is not only the stock price that has an impact on intrinsic value, and the remaining time on the option affects time value, we will examine this subject in more detail in the next few weeks.
Good luck with your trading, and have a good week!
The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.
Monetis Financial Corporation
Martin Noël earned an MBA in Financial Services from UQÀM in 2003. That same year, he was awarded the Fellow of the Institute of Canadian Bankers and a Silver Medal for his remarkable efforts in the Professional Banking Program. Martin began his career in the derivatives field in 1983 as an options market maker for options, on the floor at the Montréal Exchange and for various brokerage firms. He later worked as an options specialist and then went on to become an independent trader. In 1996, Mr. Noël joined the Montréal Exchange as the options market manager, a role that saw him contributing to the development of the Canadian options market. In 2001, he helped found the Montréal Exchange’s Derivatives Institute, where he acted as an educational advisor. Since 2005, Martin has been an instructor at UQÀM, teaching a graduate course on derivatives. Since May 2009, he has dedicated himself full-time to his position as the president of CORPORATION FINANCIÈRE MONÉTIS, a professional trading and financial communications firm. Martin regularly assists with issues related to options at the Montréal Exchange.