Tuesday, June 8, 2010

Time Value Again

A "call" option is the right to buy a stock at a set price known as the "strike price" or "exercise price." If the stock is worth $3 more than that strike/exercise price, the call option is worth that $3 difference, always. That's the intrinsic value of being able to save $3 when buying that stock. But, the option would be worth more than just that $3, as long as there is still some time left. If there is still a month to go, an ABC Aug 50 call might be trading for $4 a share, when ABC common stock is only trading for $53. The intrinsic value is $3, but there is still time for ABC to keep rising. If you want to buy this call option, you pay $4 a share, which is $3 of intrinsic value and $1 of time value. If the stock stops moving at $53, that time value will begin to evaporate quickly, as time runs out on the option. If you buy this option for $4 today, you can only win if the stock rises, and rises fast enough to outweigh the negative effects of time.

Let's work with the concept of time value in a rather annoying practice question:

Which option below has the most time value if ABC currently trades at $51 a share?
A. ABC Aug 50 call @$1.50
B. ABC Oct 50 call @2.50
C. ABC Oct 50 put @2.00
D. ABC Oct 55 put @4.25

EXPLANATION: step one, find the intrinsic value in each option and subtract that out of the premium. An Aug 50 call @1.50 has $1 of intrinsic value, 50 cents of time value. An Oct 50 call (which HAS to have more time value on it than the Aug 50) also has $1 of intrinsic value and, therefore, $1.50 of time value. Choice A is eliminated. An Oct 50 put has ZERO intrinsic value, so the time value is $2.00. Choice B is eliminated. An Oct 55 put has $4 of intrinsic value, so only 25 cents per share of time value. D is eliminated. The Answer is . . .


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