The fair price of the option is
Basics of Options Valuation
As a result, time value is often referred to as an option's extrinsic value since time value is the amount by which the price of an option exceeds the intrinsic value. Time value is essentially the risk the fair price of the option is the option seller requires to provide the option buyer the right to buy or sell the stock up to the date the option expires.
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Typically, stocks with high volatility have a higher probability for the option to be profitable or in-the-money by expiry. As a result, the time value—as a component of the option's premium—is typically higher to compensate for the increased chance that the stock's price could move beyond the strike price and expire in-the-money.
Uniquely, options have expiration dates that put a time limit on those rights. The fair value of an option is the mathematical calculation of the value of those rights based on price volatility and the time remaining on the clock. Due to Wall Street savvy and software, the current market price of an option is a close approximation of the fair value. The market price -- as stand-in for fair value -- of an option can be divided into intrinsic value and time premium.
For stocks that are not expected to move much, the option's time value will be relatively low. One of the metrics used to measure volatile stocks is called beta. Beta measures the volatility of a stock when compared to the overall market.
The Average Purchase Amount for a Pricing Strategy Stock options are financial instruments that give their owners the right to buy or sell shares in a stock at a fixed price within a specific period time. Investors use stock options as a tool with which to speculate on the changes in price of an asset or financial instrument.
Volatile stocks tend to have high betas primarily due to the uncertainty of the price of the stock before the option expires. However, high beta stocks also carry more risk than low-beta stocks.
In other words, volatility is a double-edged sword, meaning it allows investors the potential for significant returns, but volatility can also lead to significant losses. The effect of volatility is mostly subjective and difficult to quantify. When investors look at volatility in the past, it is called either historical volatility or statistical volatility.
Historical volatility looks back in time to show how volatile the market has been. Implied volatility measures what options traders expect future volatility will be.
As such, implied volatility is an indicator of the current sentiment of the market. It shows the trading price of GE, several strike prices, and the intrinsic and time values for the call and put options.
At the time of this writing, General Electric was considered a stock with low volatility and had a beta of 0. The table below contains the pricing for both calls and puts that are expiring in one month top section of the table.
The bottom section contains the prices for the GE options that expire in nine months.
Matt specializes in writing about bank stocks, REITs, and personal finance, but he loves any investment at the right price. Follow him on Twitter to keep up with his latest work!
Amazon is a much more volatile stock with a beta of 3. Let's compare the GE 35 call option with nine months to expiration with the AMZN 40 call option with nine months to expiration.