35 lines
2.4 KiB
Plaintext
35 lines
2.4 KiB
Plaintext
56 • The Intelligent Option Investor
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This is so because the area of the range of exposure for the option on
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the left that is bounded by the BSM probability cone is much smaller than
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the range of exposure for the option on the right that is bounded by the
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same BSM probability cone.
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Time Value versus Intrinsic Value
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One thing that I hope you will have noticed is that so far we have talked
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about options that are either out of the money (OTM) or at the money
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(ATM). In-the-money (ITM) options—options whose range of exposure
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already contains the present stock price—may be bought and sold in just
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the same way as ATM and OTM options, and the pricing principle is ex-
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actly the same. That is, an ITM option is priced in proportion to how much
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of its range of exposure is contained within the BSM probability cone.
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However, if we think about the case of an OTM call option, we realize
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that the price we are paying to gain access to the stock’s upside potential
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is based completely on potentiality. Contrast this case with the case of an
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ITM call option, where an investor is paying not only for potential upside
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exposure but also for actual upside as well.
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It makes sense that when we think about pricing for an ITM call option,
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we divide the total option price into one portion that represents the poten-
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tial for future upside and another portion that represents the actual upside.
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These two portions are known by the terms time value and intrinsic value,
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respectively. It is easier to understand this concept if we look at a specific
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example, so let’s consider the case of purchasing a call option struck at $40
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and having it expire in one year for a stock presently trading at $50 per share.
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We know that a call option deals with the upside potential of a stock
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and that buying a call option allows an investor to gain exposure to that up-
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side potential. As such, if we buy a call option struck at $40, we have access
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to all the upside potential over that $40 mark. Because the stock is trading
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at $50 right now, we are buying two bits of upside: the actual bit and the
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potential bit. The actual upside we are buying is $10 worth (= $50 − $40)
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and is termed the intrinsic value of the option.
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A simple way to think of intrinsic value that is valid for both call options
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and put options is the amount by which an option is ITM. However, the option’s
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cost will be greater than only the intrinsic value as long as there is still time |