For investors interested in getting started with options, the way these instruments work can seem intimidating. An option's price is made up of two components: intrinsic value and time value.
In this segment from Motley Fool Live that first aired May 7, Motley Fool Canada analyst Jim Gillies and Fool.com editor/analyst Ellen Bowman discuss how each one works.
Jim Gillies: Option prices are comprised of two components. You know all this. [LAUGHTER]
Ellen Bowman: That doesn't mean I don't need to hear it.
Gillies: Okay. Option prices, as you say, but for the Fools watching who maybe don't know this. An options price is two components, intrinsic value and time value. Intrinsic value is just the difference between the stock price and the strike price with a bottom of zero. We're talking about $145 calls on Apple (AAPL 2.15%) right now with the stock price of 130 minus strike price of 145, that's minus 15, but we can't do negative numbers with intrinsic value. If it's below zero, you just call it zero.
Bowman: Easy enough.
Gillies: But if we were talking about the $120 call option today on Apple, stock price of 130 less 120 strike price, that's $10. We would have intrinsic value of $10. A call option is stock price minus strike price, for put option, which we're not going to get into. Put option is strike price less stock price, but it's always the difference between those two things.
Bowman: Yeah. It's the spread for lack of a better word between that.
Gillies: For lack of a better word, yeah, it's actually good. You run with it, but again, zero you don't worry about it. Then you look at the options price. Again, our August $145 call options on Apple, we've just established there's no intrinsic value because the strike price is well above the stock price. You look at the price, it's about $2.70, that is all time value. Time value is the amount of premium the option is demanding or the options market is demanding because it doesn't know which way the stock is going to go. It could go up, it could go down, it could rocket to the moon, could be under sideways, we don't know. The options market is saying because of that uncertainty, here is what we are going to demand, and in this case, it's $2.70. But that's on May 7th.
Bowman: Right.
Gillies: As the 3rd Friday in August, an options standard expiration options Friday, standard expiration Friday is the third Friday of each month. As August 20th approaches, that $2.70, let's say Apple goes nowhere, it just stays at 130 for the next three and a bit months.
Bowman: Okay.
Gillies: That $2.70 will gradually decline until at expiration it reaches zero.
Bowman: The money I'm getting paid to sell this call is a quantification, there's the difference between the prices unless it's zero, in this case, the intrinsic value is zero. But it's like a quantification of the time it's going to pass. That's why if I was going to buy something that expired in a week, I would just say 19 cents.
Gillies: Yeah.
Bowman: But we go further out. ... Time decay, is it linear or not so much?
Gillies: No.
Bowman: Decay is more rapidly as expiration approaches by this week is worth 19 cents, but the day before it'll be worth a penny.
Gillies: Yeah, we've got actually an article in Motley Fool Options which Jim Mueller, I think I called it "Tempus Fugit," might be one of the few ones.
Bowman: Yeah, I remember "Tempus Fugit."
Gillies: It basically grabs out the time decay, and it basically looks like this, Ellen. It's as time passes, and then the last week, it ... [gestures] ... Remember, we talked about an option is some of intrinsic value and time value? The dirty little secret, with one exception and that's dividends, we'll get to that in a minute, but pretend the stock doesn't have a dividend. Ignore intrinsic value, time value. If time value is anywhere above zero, anywhere above $0.05 basically, your option will not be assigned early, absenting a special case of dividends, but will not be assigned early against you because it makes more sense, and it provides more profit to the counterparty rather than exercising the option, taking your shares and then selling them. It makes more sense to sell the option.
Bowman: Yeah.
Gillies: We've been talking about the 145 strike here. Obviously, no one's going to take your shares and pay you 145.
Bowman: If it were 132, yeah.
Gillies: Yeah. They're going to go, "Well, no, I'm just not going to hand Ellen 15 free dollars."
