When trading options, you are trading premium value. If you buy an option, you want to sell it in the future for a higher premium, and if you sell an option, you want to buy it back for less.
Premium value is comprised of two parts: Intrinsic value and time value. These values change as the underlying market changes.
Premium = Intrinsic Value + Time Value.
This is the portion of the premium that depends on the difference between the strike and the market rate. When the option is in-the-money (when the strike rate is greater than the market rate) the option has intrinsic value. But if the option is out-of-the-money or at-the-money, the intrinsic value is zero. When intrinsic value is zero, it does not mean the premium is zero as it may still have time value!
Calculating intrinsic value
The platform automatically calculates the premium value for you and it is updated every second the market is open, but it’s always good to know the workings behind it.
Let’s say you buy a EUR/USD Put with a strike of 1.3600 and an amount of 100,000 EUR.
If the underlying market is trading at 1.3500, your strike rate (to sell) is 100 pips better than the market, hence your trade is in-the-money (ITM). We calculated this by subtracting the market rate (1.3500) from the strike rate (1.3600) giving us 0.0100 or 100 pips. In fact, whenever the market is trading below 1.3600, the Put option has intrinsic value.
More specifically, when the market rate is 1.3500,
Intrinsic value = Amount x Difference between strike and market rate
= 100,000 x (1.3600 – 1.3500)
= 100,000 x 0.0100
Therefore, the Put option’s premium = $1000 + Time Value.
On the other hand, if the market is trading at 1.3600 or higher, the strike rate is not greater than the market rate, hence intrinsic value = 0 and premium is comprised of time value only.
Time value, also known as extrinsic value, is the portion of the premium left after deducting the intrinsic value and is determined by external factors: Time Value = Premium – Intrinsic Value.
Premium can increase or decrease depending on time value and the two main external factors are time until expiry and implied volatility.
Options with a longer expiry are more expensive since you are buying more time for the market to move in your favour. The opposite is also true, options with a closer expiry cost less. When holding an option, the expiry date moves closer for each day passing. The time value portion of the premium declines reflecting this. At expiry, time value equals zero and the premium equals intrinsic value only. The process of time value declining each day towards zero until expiry is known as Time Decay.
Time decay is bad for an option buyer, who wants the premium value to increase, and good for an option seller, who wants the premium value to fall.
The Scenarios trading tool gives the option’s premium value over a range of market prices. You can choose to view the premium now or premium at expiry. The values at expiry have no time value, hence they are intrinsic value only. The premium now is an indication of the option’s value before expiry, hence there is time value. We can conclude time value is the difference between premium now and the premium at expiry.
Net Present Value (NPV)
Net Present Value (NPV) figures are an indication of what your option trade’s ‘premium now’ would be if the market moved. The indication is based on the current market environment. The Scenarios and Sensitivity trading tools provide NPV values over a range of market rates. This is useful to forecast the trade’s pay-out.
If you are long (through buying) an option, then the NPV value will be positive and this is the amount you will receive when you sell your option back. The example below is a snap-shot of the sensitivity table for a long Call option. The NPV column indicates how the option’s value will change as the underlying market moves.
If you are short (through selling) an option, then the NPV value will be negative and this is the amount you will pay to buy back the option. The example below is a snap-shot of the sensitivity table for a short Call position. The NPV column indicates the cost to the seller as the underlying market moves.
The marketplace’s volatility affects an option’s premium (time value portion). Expected volatility, known as implied volatility, is based on marketplace consensus. If the market is expecting more volatility, you will pay more for the option. This makes sense because the more volatility in the underlying asset, the more likely the market will move in your favour.
There are other external factors affecting the extrinsic value, and to fully understand all these elements, you will to learn them via The Greeks available in later lessons.
- If the implied volatility increases after an option trade has been purchased, this is good for the buyer and bad for a seller. Buyers like increasing volatility!
- At any time, your option’s premium will be at least the intrinsic value. At expiry, time value = 0 and the premium = intrinsic value.