Intrinsic Value and Time Value in Stock Options
A stock option's total value consists of two components: intrinsic value and time value. Options will only have intrinsic value if they are in-the-money. The intrinsic value of an in-the-money option is equal to the difference between the option's strike price and the current value of the underlying stock. For example, if IBM is trading at 69.20, an IBM May 65 call will have an intrinsic value of 4.20 (69.20 - 65 = 4.20), and an IBM May 70 put will have an intrinsic value of 0.80 (70 – 69.20 = 0.80). Obviously, the deeper a stock option is in the money, the higher the intrinsic value will be.
Any value in an option above its intrinsic value is time value. Time value is calculated by subtracting intrinsic value from total value. Continuing with our example from above, if the IBM May 65 call has a premium of 7.80 with an intrinsic value of 4.20, the time value will be 3.60 (7.80 – 4.20). If the May 70 put has a total value of 3.80 with a 0.80 intrinsic value, the time value will be 3 (3.80 – 0.80 = 3). The more time a stock option has remaining until expiration, the higher its value will be since additional time improves the chances that the option will make the desired move.
Converting a Coca-Cola April 75 Call Into Option Symbol KODO
Seeing a stock option listed as a Coca-Cola April 75 call, you may easily recognize that the Coca-Cola call expires in April and has a strike price of 75. An option listed as KODO, however, may not immediately relay to you the same information even though KODO is the option symbol for the Coca-Cola April 75 call.
Converting an option into its option symbol is quite simple if you know how, and probably the best way to learn how is to work through an example. To avoid confusion, let's continue with our Coca-Cola example:
1. The first step is to list the underlying stock's ticker symbol. In this case Coca-Cola's ticker is "KO." The option symbol ticker may be no longer than three letters and can be as short as one. For over-the-counter stocks with more than three letters in the stock code, the option ticker symbol will be shortened to three letters, usually ending in "Q." For example, Microsoft Corp.'s stock ticker is MSFT which is shortened to "MSQ" for its option ticker.
Step 1 Results = KO
2. The next element is a letter designating the month of the option's expiration date and indicating whether the option is a call or a put. Each expiration month has a separate code for both calls and puts (see Table 1 below). In our example, an April call is represented by the letter "D" whereas an April put would be denoted with a "P."
Step 1 Results + Step 2 Results = KOD
| Table 1: Expiration Month |
| Month | Call Code | Put Code |
| January | A | M |
| February | B | N |
| March | C | O |
| April | D | P |
| May | E | Q |
| June | F | R |
| July | G | S |
| August | H | T |
| September | I | U |
| October | J | V |
| November | K | W |
| December | L | X |
3. The final element in the option symbol is the option's strike price. The strike price letter is the same for both calls and puts (see Table 2 below) In our example, the strike price indicator is the letter "O". The letter "O" corresponds to the strike price of $75/share (or, in other cases, $175 for a stock that is trading near the $175/share range).
Step 1 Results + Step 2 Results + Step 3 Results = KODO
| Table 2: Strike Price Symbol
|
| Code | Striking | Prices | Code | Striking | Prices |
| A | 5 | 105 | N | 70 | 170 |
| B | 10 | 110 | O | 75 | 175 |
| C | 15 | 115 | P | 80 | 180 |
| D | 20 | 120 | Q | 85 | 185 |
| E | 25 | 125 | R | 90 | 190 |
| F | 30 | 130 | S | 95 | 195 |
| G | 35 | 135 | T | 100 | 200 |
| H | 40 | 140 | U | 7.5 | 37.5 |
| I | 45 | 145 | V | 12.5 | 42.5 |
| J | 50 | 150 | W | 17.5 | 47.5 |
| K | 55 | 155 | X | 22.5 | 52.5 |
| L | 60 | 160 | Y | 27.5 | 57.5 |
| M | 65 | 165 | Z | 32.5 | 62.5 |
Following this three step process is an easy way to convert options into their option symbols. For easy access, you may want to either bookmark this page or print it out to use Tables 1 and 2 as quick references.
How Stocks and Stock Options Differ
Unlike stocks, options have a limited life. If an expected move does not immediately occur, a stock investor can say, "I'll give it another week." This is not always true with options trading. Each option has a set expiration date. At expiration, an option is either worth the difference between its strike price and the current stock price, or it's worthless.
There are a couple of key factors to keep in mind when dealing with the limited life of options. The first key factor is the understanding that an option's value depends on the ability to correctly predict both the direction and timing of a move in the price of the underlying stock. The first variable, direction, is easily understood. If the expectation is that the underlying stock price will go up but instead it goes down, the investor loses money. (However, an options investor could earn money if the expectation is that the underlying stock price will drop and the price does drop.) The second key variable in options trading is the timing of the direction. For instance, the holder (buyer) of a Dun & Bradstreet May 35 call is guaranteed the right to buy 100 shares of the stock at $35 per share at any time before the option's May expiration, even if the stock rallies to $40, $50, or even $70 per share. However, it costs more to pay for a July 35 call than a May 35 call, because of the additional time, and therefore, improved likelihood, that the stock will rally above the price of $35 per share.
Dividends are another key difference between stock and option trading. Dividends do not represent a change in value to the holder of a stock, because the stock price moves down approximately the same value as the dividend paid to the shareholder. This is not true in options. An option does not give the holder the right to receive a dividend. Thus, when a dividend is paid and the stock subsequently falls, an option holder bears the full brunt of the dividend paid. While this is a negative characteristic for a holder of a call option, the holder of a put option, who is betting the stock will go down anyway, actually gains from this occurrence. Of course, the options market anticipates the impact of upcoming dividends and tends to discount for this effect just before the dividend is paid. Remember, an option does not give the holder ownership rights, voting rights, or a share of the company; it entitles the owner to benefit only from the stock's price movement.
The Three Styles of Exercise Features
An option can have three different styles of exercise features: American, European, and Capped. An American contract may be exercised at any time before its expiration date. Most options, including equity options, are American-style.
A European contract is exercisable only on the expiration date, known as the settlement date. Options on the Standard & Poor's 500 Index are examples of European-style options.
A Capped option gives you the right to exercise that option only during a specified period before its expiration, unless the option reaches the cap value prior to expiration, in which case the option is automatically exercised. Capped options are the least commonly used style of options in the United States.
8 Myths About Stock Options
For years, the options market was shrouded in mystery as transactions took place with obscure options dealers who set the prices and terms of options contracts. The Chicago Board Options Exchange (CBOE) created "listed options" that became the standard, and option prices were set in an auction market nearly identical to the stock exchanges. For the first time, this allowed the option holder to choose to sell his contract on the open market before it expired.
Trading volume in listed options has exploded and option trading on more than 2,400 different equities and indices now accounts for the equivalent of 110 million shares of stock trading each day. But many of the myths associated with options have lingered. Unfortunately, these myths have caused many investors to remain on the sidelines while they could be utilizing options profitably or for reducing risk.
Myth #1:
90% of Options Expire Worthless.
This "statistic" is often bandied about by those who have no experience trading options. According to the CBOE, about 30% of all options expired worthless -- a far cry from 90%.
Myth #2:
Options are Much Riskier Than Stocks or Mutual Funds.
This assumes that the investor is trading options with the same amount of capital that he would devote to stocks or mutual funds. On a "dollar for dollar" basis, options are riskier. Here at Schaeffer's Investment Research, we never recommend trading options in this manner. Instead we show our subscribers that options are a cheap way to reduce their overall risk. How? First, by limiting their total dollar exposure to a fraction of what they would invest in stocks or mutual funds. Second, by diversifying their options portfolio among different underlying equities. And third, by purchasing both call and put options, since put options are profitable when the underlying stock declines in prices.
Myth #3:
Option Sellers Make Profits at the Expense of Option Buyers.
Unlike the gambling casino (or the lottery or the race track) which has built-in percentage advantages for the "house," option trading is a "zero sum game" in which option sellers and buyers are always at a standoff in total. Option buying and selling differ only in the distribution of their outcomes, not in their relative profitability. Although option buyers can have more losing than winning trades, they never lose more than their original investment and their profit potential is unlimited. Option sellers profit most of the time but their potential losses are unlimited. Schaeffer's Investment Research has always been dedicated to maximizing profit potential through option buying -- by taking full advantage of the unlimited profit potential and limited risk of this strategy.
Myth #4
The Big Losses in the 1987 Crash Were Suffered by Option Buyers.
The big losses in the 1987 crash were suffered by those who sold put options. The unfortunate put sellers in 1987 experienced losses of such great magnitude that many of them could not meet their obligations. Many put option buyers, on the other hand, scored big profits in 1987.
Myth #5
Options are Too Complicated.
Nonsense! Anyone who is familiar with stocks can easily learn how to trade options. The approach to option trading that we use at Schaeffer's Investment Research is very simple. If we are bullish on a stock, we advise you to buy a call option on that stock. For a fraction of the underlying stock price, you "rent" any appreciation in the stock above a particular price for a specified time. If we are bearish on a stock, we advise you to buy a put option. Here you "rent" any decline in the underlying stock below a particular price for a specified time. It's that simple!
Myth #6
Stockbrokers Don't Understand Options and are not Interested in Options Business.
While this may have been a problem 10 years ago, the brokerage landscape has significantly changed for the better. A number of brokerage firms now specialize exclusively in options. Many large discount brokers have become "option trader friendly." Some traditional full-service firms have developed expertise in options and the desire for options business.
Myth #7
You can't Beat the "Option Pricing Model."
Since options are a "zero-sum game," and option prices are based upon a mathematical "option pricing model," some say it is impossible to profit from buying options in the long run. WE STRONGLY DISAGREE. First, prices for exchange-listed options are set in the marketplace by buyers and sellers, although the computerized pricing models do exert a strong influence. But more importantly, these models are based upon the mistaken assumption that all stock price movement is "random." Clearly, there are always certain stocks that are moving in well-defined price trends, as opposed to moving randomly. If you can identify those stocks whose price trends are likely to continue, you can beat the option pricing model! Much of our research has been devoted to developing indicators to determine stocks that will continue moving in such price trends, so our subscribers can profit from buying undervalued options on these stocks.
Myth #8
Options Trading Requires Too Much Time.
Amateurs are rarely successful trading options because they don't have the time, information, expertise or the discipline to compete in this fast-moving market. But Schaeffer's Investment Research subscribers have a big edge over these amateurs. First, our staff of professionals here at Schaeffer's Investment Research have the information and expertise to make you a successful options trader. And second, we give you the disciplined trading rules that help you make big money and also minimize your time commitment to your options trading! We tell you how much to pay, when, and at what price to sell.
A Brief History of Stock Options
On April 26, 1973, the Chicago Board Options Exchange (CBOE) opened and traded the first standardized, exchange-listed equity option. Although the CBOE listed only call options on 16 underlying stocks, a revolutionary new financial instrument had been created. The CBOE traded just over one million option contracts during the first year.
To help insure the stability and integrity of the options market, the Options Clearing Corporation (OCC) was also started in 1973. Composed of more than 135 Clearing Members, the OCC is the issuer and registered clearing facility for all exchange-listed securities options in the U.S.
Over the next few years, options became popular and other securities exchanges began entering the business. The American Stock Exchange and the Philadelphia Stock Exchange started trading options in 1975, and the Pacific Stock Exchange introduced option trading in 1976. In 1977, put options became exchange listed and expanded the benefits of options. On March 11, 1983, the CBOE transformed options trading when it introduced index options in the form of the S&P 100 Index. The New York Stock exchange joined the others and introduced option trading in June 1985. (Subsequently the New York Stock exchange sold its options business to the Chicago Board Options Exchange in 1996.) In May 2000, the International Securities Exchange started trading options as the nation's first entirely electronic options market.
In response to the heavy interest in options, the Options Industry Council (OIC) was founded in 1992 by the nation's options exchanges. A non-profit organization, the OIC works to educate investors on the risks and rewards of options trading. Investors have access to free educational videos, software, brochures, and evening seminars through the organization.
As testimony to the popularity of options trading, options are available today on over 2,400 underlying securities and numerous indices and exchange-traded funds. In 2005, a record volume of more than 1.3 billion equity option contracts traded across the six exchanges, more than double the volume just five years earlier. This was the 13th year of increasing volume out of the past 14 years.
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