Options buyers and sellers measure the value of
an options contract by how likely it is to meet their expectations.
In the language of options, that's determined by whether
or not the option is currently or is likely to be
in
the money.
A call
option
— giving the holder an option to buy
— is in the money if the current
market
value
of the underlying interest is above the
exercise
price
of the option. A
put
option
— giving the holder the option to sell
— is in the money if the current market value of the underlying
interest is below the exercise price. Specifically, being in the money
means that the holder can exercise the option at a potential profit.
If it's not in the money at the expiration date, it's
worthless.
An option's premium has two parts: an
intrinsic
value
and a time value. Intrinsic value is the amount
by which the option is in the money. Time value is the difference
between whatever the intrinsic value is and what the premium is.
Finding
values
For
example
Share
market price
- Exercise price
_______________
= Intrinsic value
$30
- $25
______
= $5
Premium
- Intrinsic value
_______________
= Time value
$6
- $5
______
= $1
For example, if the current market price of ABC
stock is $30, a call option on that stock with an exercise price
of $25 has an intrinsic value of $5 because it is $5 in the money.
If the current premium on the option is $6, the time value is
$1.
The ins
and outs of options
At the money: When the market price
and the strike price are the same
Out of the money: When the market
price is lower than the exercise price of a call option
and higher than the exercise price of a put option
Deep out of the money: When the strike
price is so far from the market price that there's
little trading — also known as DOOM
