38 lines
1.6 KiB
Plaintext
38 lines
1.6 KiB
Plaintext
The Intelligent Investor’s Guide to Option Pricing • 57
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before the option expires. The reason for this is that although the intrinsic value
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represents the actual upside of the stock’s price over the option strike price,
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there is still the possibility that the stock price will move further upward in the
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future. This possibility for the stock to move further upward is the potential bit
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mentioned earlier. Formally, this is called the time value of an option.
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Let us say that our one-year call option struck at $40 on a $50 stock
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costs $11.20. Here is the breakdown of this example’s option price into in-
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trinsic and time value:
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$10.00 Intrinsic value: the amount by which the option is ITM
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+ $1.20 Time value: represents the future upside potential of the stock
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= $11.20 Overall option price
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Recall that earlier in this book I mentioned that it is almost always a mis-
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take to exercise a call option when it is ITM. The reason that it is almost always
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a mistake is the existence of time value. If we exercised the preceding option,
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we would generate a gain of exactly the amount of intrinsic value—$10. How-
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ever, if instead we sold the preceding option, we would generate a gain totaling
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both the intrinsic value and the time value—$11.20 in this example—and then
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we could use that gain to purchase the stock in the open market if we wanted.
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Our way of representing the purchase of an ITM call option from a
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risk-reward perspective is as follows:
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Advanced Building Corp. (ABC)
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5/18/2012 5/20/2013 249 499 749
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EBP = $51.25
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999
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100
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90
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80
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70
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60
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50
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40
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30
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20
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Date/Day Count
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Stock Price
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GREEN
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ORANGE |