Equity and Index Options Explained

5

Option Price and Value

GLOSSARY

Arbitrage: The exploitation of anomalies in pricing between different markets and instruments

Settlement price: The price at which an instrument closes at the end of the trading session

Option prices may be broken down into two parts; intrinsic value and time value (USA = extrinsic value).

Depending upon the specific circumstances, an option price may consist only of intrinsic value, it may consist only of time value or it may consist of both intrinsic and time value.

Intrinsic value is the value of an option if it were exercised now. In other words, it is the difference between the option's strike price and the prevailing price of the underlying.

EXAMPLES OF INTRINSIC VALUE

Stock XYZ is trading at £5.00.

Consider the XYZ £4.50 call. The XYZ £4.50 call confers the right to buy XYZ shares at £4.50. If this right is exercised, then the shares bought for £4.50 can be sold on the open market at the prevailing price of £5.00; a difference of £0.50. This £0.50, this difference between the strike price (£4.50) and the prevailing share price (£5.00), is the intrinsic value of the call:

INTRINSIC VALUE OF CALL = UNDERLYING PRICE MINUS STRIKE PRICE

Consider the XYZ £6.00 put. The XYZ £6.00 put confers the right to sell XYZ shares at £6.00. If this right is exercised, then the shares sold at £6.00 can be bought back on the open market at the prevailing price of £5.00; a difference of £1.00. This £1.00, the difference between the strike price (£6.00) and ...