By Gary, on November 19th, 2012
Have you ever asked yourself how to find the best price to pay for a Call Option or do you just rely on your financial broker recommending the right option for you to buy? If you have ever wondered how to calculate the best price for an option contract, and want to find out, you will need to learn a few terms and understand them so you can make a good decision on what price is the best price for you and your financial plan.
So – how do you define cheap? $1.00? How do you define expensive? $200.00? Your call, but let’s give you some ammunition.
There is the cost paid to own the option – most call this the intrinsic value. There is the cost to have the luxury of time to make money – this is called the time value or hyped value. Therefore, the cost of an option is the intrinsic value plus the time value:
IV + TV = Price of Option
Now, once you have this, it will help you determine if buying the option is worth your while or not. You really want to have an understanding the ratio between the intrinsic and the time value of the option. One general rule of thumb is that if the time value is high, the time to exercise the option should be generous and conversely if the time value is low, the time to exercise the option should be very short. You have heard of “day traders”? They buy options that have deadlines that fall within market trading hours so they have to be very knowledgeable and precise with their options. Let’s look at a couple of examples.
- It is mid-April and ABC stock is at $69. The May 65 call gives you the right to buy 100 shares of the stock at $65 per share within just a few weeks. If the price of the May 65 call is set at $4.50 per share. You sell at $65 the second week of May. You make a profit of $4 per share which puts the intrinsic value at $4 per share. That leaves a time value of $0.50 per share.
Remember IV + TV = Price? $4.00 (IV) + $0.50 (TV) = $4.50 (Price)
- Let’s compare example May 65 call priced at $4.50 per share with the Sep 65 call with a price attached at $7.50 per share. If the intrinsic value stays at $4.00, then the time value for this call is $3.50. This shows that if you control the stock for one month, the time value is $0.50 and if you control the stock for five months the time value of the price becomes $3.50. Therefore “time is money”.
You have to decide whether to be precise and buy a short term call with a low time value or give the stock a chance to move by paying a higher time value and allowing more time to hit your price.
So now you understand how to value a call option. You can price calls by determining what you price needs to be to make money given the intrinsic value and the time value of that price.
Say you need to make $1.50 per share and the intrinsic value is at $2.00 per share and the time value is at $1.00, you need the sell price to be ≥ $4.50 per share.
If you experiment with intrinsic and time values and their relationships to the price of the options, you will see how to buy smart and how to control the options to your benefit.