Option Value
The price of an options can be broken down into two parts: extrinsic value and intrinsic value.
Intrinsic Value
Intrinsic value is the portion of the option that can be realised if the option is exercised. Therefore, only in-the-money options have intrinsic value.
Consider the following example:
Underlying: Microsoft
Underlying Price: MSFT $30
Type: Call Option (American)
Strike Price: $25
Expiry Date: 30th September
Now, imagine that this particular call option is currently trading at $7. How can we better understand this price?
Well, the first part we can look at is it's Intrinsic Value: the value of the option that, if exercised, would result in a profit. We know that the call option's strike price is $25 and with Microsoft trading at $30 it is already worth at least $5.
This is what's known as Intrinsic value - the value that can be made by exercising the option.
Extrinsic Value
When an option is trading at more than the intrinsic value, the difference is known as Extrinsic Value, or more commonly known as Time Value.
Looking at the previous example, we have already determined that the option is worth at least $5 - its Intrinsic Value. However, it is actually trading at $7.
The remaining $2 is called Extrinsic Value and represents the markets view of how far the underlying could trade as high as by the time the contract expires.
Sometimes an option can have 0 Intrinsic Value but can still be worth something in the market. Why?
This is because traders believe that there is still some chance that the underlying could trade in a favorable direction, which would make the option profitable.
An option that has 0 Intrinsic Value is said to be out-of-the-money, i.e. if your were long (you bought) this call option and you exercised it, you would lose money by being assigned Microsoft shares at the exercise price $37, which are actually worth only $36 on the open market, leaving you with a loss of $1.
So, the call option has zero Intrinsic Value. Yet it's price in the market is $1.75. Does this mean that the option is over valued? Not really. It simply means that because the option still has 6 months until expiry, there is still plenty of time for the option to exceed the exercise hurdle of $37.
If the option expired tomorrow, it would have almost zero Extrinsic Value and zero Intrinsic Value - therefore being considered worthless. This is because the call option only has one day left for it to trade higher than $37 to give the trader a chance at making money from it.
However, because the option doesn't expire for another 6 months, there are approximately 120 days (or 120 chances) that Microsoft has to trade another dollar higher and therefore turn this option into an in-the-money option.
My question is whether the exercise price of $37 is from the Microsoft share which is $30 and $7 from trading value. if yes, how about $36? where the sum ($36) comes from? thanks. I hope you understand what i am trying to ask :)
It depends. You can download my spreadsheet:
http://www.optiontradingtips.com/pricing/free-spreadsheet. html
or view an online calculator like:
http://www.option-price.com
what is the fair value of a call option? is it what you refered to above?
Thanks