Option Contracts. An option represents a right, rather than an obligation, to either buy or sell some quantity of a particular underlying. The option is valid for a specified period of time and calls for a specified buy or sell price, referred to as the strike price or exercise price. If an option allows the holder to buy an underlying, it is referred to as a call option. An option that allows the holder to sell an underlying is referred to as a put option.
Options are actively traded on organized exchanges or may be negotiated on a case-by-case basis between counterparties (over-the-counter contracts). Option contracts require the holder to make an initial nonrefundable cash outlay, known as the premium, as represented by the option’s current value. The current value of an option depends on forward periods and spot prices. The difference between the strike and spot price, at any point in time, measures the intrinsic value of the option, so changes in spot prices will change the intrinsic value of the option. Changes in the length of the remaining forward period will affect the time value of the option. The time value is measured as the difference between an option’s current value and its intrinsic value as in the following.
- If the option is in-the-money, the option has intrinsic value. For example, if an investor has an April call (buy) option to buy IBM stock at a strike price of $110 and the current stock price is $112, the option is in-the-money and has an intrinsic value of $2. An option that is out-of the- money or at-the-money has no intrinsic value.
- The difference between the current value of an option and its intrinsic value represents time value. For example, if the IBM April call (buy) option has a current value of $8, the time value component is $6 (the current value of $8, less the intrinsic value of $2). The time value of an option represents a discounting factor and a volatility factor.
- The discounting factor relates to the fact that the strike price does not have to be paid currently, but rather at the time of exercise. Therefore, the holder of an option to buy stock could benefit from an appreciation in stock value without actually having to currently pay out the cash to purchase the stock. For example, assume that a 30-day, at-the-money option has a strike price of $100 and that a discount rate of 12% is appropriate. The ability to use the $100 for 30 days at an assumed discount rate of 12%, rather than having to buy the stock at the current price of $100, is worth $1 ($100 12% 1/12 year). Thus, the ability to have the alternative use of the cash equal to the strike price until exercise date of the option has value.
- The volatility factor relates to the volatility of the underlying relative to the fixed strike price and reflects the potential for gain on the option. Underlyings with more price volatility present greater opportunities for gains if the option is in-the-money. Therefore, higher volatility increases the value of an option. Note that volatility could also lead to an out-of-the-money situation. However, this possibility can be disregarded because, unlike forward or futures contracts, the risk for an option is asymmetric since the holder can avoid unfavorable outcomes by allowing the option to expire.
- The value of an option can be realized either through exercise of the option or through cash settlement. If the option can be exercised any time during the specified period, it is referred to as an American option; if it is exercisable only at the maturity date/expiration of the contract, it is referred to as a European option.