PepsiCo (NYSE:PEP) shares sell for \$57. You like the company. You like the price. In fact, you really like the price. You like it so much that in addition to buying shares outright, you decide to augment your potential gains by buying some call options. If you're right, the price of the shares will rise and drag the value of the options with it. But which options should you buy? What strike price? What expiration date? How will the option price behave as the stock price rises? What if the stock price falls? What happens as we approach the expiration date?

Two-component pricing
An option's price is the sum of two components: intrinsic value (IV) and time value (TV).

Option value = IV + TV

IV is the difference between the stock price and the option's strike price. However, IV cannot be less than zero, since the optionholder wouldn't exercise a call with a strike price of \$30 if the same stock is trading in the market at \$25. (If you know someone who would do such a thing, please email me their contact information.) IV is calculated based on how the underlying stock price moves in relation to the option strike price:

Stock Price < Strike Price

Stock Price > Strike Price

Stock Price = Strike Price

Call

\$0

Stock Price - Strike

\$0

Put

Strike Price - Stock Price

\$0

\$0

TV is simply the premium that people are willing to pay for the potential upside of the stock until expiry. Options are "wasting assets" -- that is, as time passes and expiration approaches, TV gets progressively smaller until you're out of time, at which point TV = 0. The corollary is that at expiry, the option's value is simply IV. Prior to expiry, TV is always positive, even though it may be very, very small.

Back to reality
Consider the following General Electric (NYSE:GE) calls, a stock which currently sells for \$13.30:

Option Number

Strike Price

Price

Expiry

IV

TV

1

\$10.00

\$3.45

Sep-09

\$3.30

\$0.15

2

\$10.00

\$3.60

Dec-09

\$3.30

\$0.30

3

\$10.00

\$3.80

Mar-10

\$3.30

\$0.50

4

\$15.00

\$0.21

Sep-09

\$0

\$0.21

5

\$15.00

\$0.61

Dec-09

\$0

\$0.61

6

\$15.00

\$0.99

Mar-10

\$0

\$0.99

There are three key observations from this table:

1. Any time the strike price is greater than or equal to the current stock price, IV is zero. In such cases, the option value is solely attributable to TV, and the expectation (hope?) is that the stock price will meander back above the strike price by expiration.

2. The less time remaining until expiry, the lower the TV. (Presumably, this is intuitive.)

3. For options with a common expiry date, TV is maximized when the strike price and the stock price are equal. As the stock price moves in either direction, TV falls.

Money-ness
You'll hear phrases like "in the money" or "out of the money" bandied about. This is just a fancy way of denoting whether an option has intrinsic value or not. If IV is positive, the option is said to be in the money. If IV is zero, it's termed out of the money.

Walgreen (NYSE:WAG) shares trade for \$31. A call with a strike of \$25 is in the money, while a \$35 call is out of the money. Conversely, a \$25 put is out of the money, and a \$35 put is in the money.

Expressing options as the sum of IV and TV also leads to the conclusion that early exercise of options generally doesn't make sense (though there are, as always, exceptions to the rule). The thinking goes like this:

1. An option is worth IV + TV.

2. I can exercise it now and receive IV, or

3. I can sell the option and receive IV + TV.

4. IV + TV is more than IV. Therefore, selling an option rather than exercising early is the superior choice.

Starbucks (NASDAQ:SBUX) trades for \$17.70. So if you own \$16 October calls, instead of exercising early to collect the \$1.70 spread (\$17.70-\$16), you would want to sell your calls for \$2.42.

There is always the potential for option holders to act irrationally and exercise, even though doing so means they give up TV that they could have harvested by selling the option. Fortunately, such cases are rare. There is, however, a situation where early exercise may become an issue.

Options on dividend-paying stocks
A company paying a dividend, particularly a hefty one-time dividend, can provoke early exercise. Theoretically, a stock's price falls on the ex-dividend date by the amount of the dividend. Option holders don't receive the dividend, though, so they might sell the option before the ex-dividend date to avoid the price drop.

If, however, the dividend is greater than the remaining TV of an option, then early exercise can make sense.

Consider Paychex (NASDAQ:PAYX), which yesterday sold for \$26 when its regular \$0.31 dividend went ex-dividend. At the time, a \$20 call option, expiring in three weeks, sold for about \$6.20. So this option had an IV of \$6 and \$0.20 of TV. Assuming that the stock price falls by the amount of the dividend as anticipated (and for ease of calculation, we'll assume the stock price stays flat to expiry), the option holder is better served by exercising early.

Early exercise means that the option holder pays \$20 for shares currently worth \$26. He then receives a dividend of \$0.31 and continues to hold shares worth \$26. Conversely, holding the option through the ex-dividend date until expiry sees the remaining TV dissipate, and the holder ends up with just the shares worth \$25.69.

Intel (NASDAQ:INTC), which trades for \$19.40, has \$14 August calls with an intrinsic value of \$5.40 (\$19.40-\$14.00). With a bid price of \$5.45, their time value is \$0.05. Since the upcoming quarterly payout is \$0.14, call owners would want to exercise early to capture the dividend for themselves.

Bidders for DuPont (NYSE:DD) \$28 August calls are offering \$3.10. With shares trading for \$31.07, the calls’ time value is just \$0.03. Call holders would definitely want to exercise early and collect the \$0.41 payout that goes ex-dividend just before their expiry.

The Foolish bottom line
Options can be a valuable tool to help you make money in up, down, and flat markets. But as with any tool, it’s important to make sure you understand them so you can use them effectively. If you’re interested in learning more, check out our free video series – just enter your e-mail in the box below for access.

This article was originally published on April 24, 2007 under the headline “Options Pricing: A Beginning.” It has been updated.

Jim Gillies doesn’t own shares of any company mentioned. Intel, Paychex, and Starbucks are Inside Value recommendations. Starbucks is also a Stock Advisor selection. Paychex and PepsiCo are Income Investor picks. The Fool owns shares of Starbucks and has a disclosure policy.