One reason serious investors love options is that they can be used for so many different strategies.

Think a stock is going to rise? If you’re right, buying a call option gives you the right to buy shares later at a discount to the market value, allowing you to profit from the rise. Want some protection should your stock unexpectedly plummet? Acquiring a put option gives you the ability to sleep easy, knowing you can sell it later at a pre-determined price and limit your losses. The number of possible strategies goes on and on.

Options can open the door to big gains or provide a safeguard against possible losses. And, unlike actually buying or short-selling shares, you can obtain a significant position in the stock with a modest upfront commitment.

Regardless of whether you’re buying or selling these contracts, understanding what goes into an option’s price, or premium, is essential to long-term success. The more you know about the premium, the better you can recognize a good deal and back out of transactions when the odds are against you.

There are two basic components to an option's premium.

Intrinsic Value

The first is the “intrinsic value” of the contract, which is simply the difference between the "strike" or exercise price (the price you can buy or sell an asset in the options contract) and the asset's current market price.

For instance, say you bought a call option for XYZ Company with a strike price of $45. If the stock is currently valued at $50, the option has an intrinsic value of $5 ($50 - $45=$5). In this case, you could buy the call and exercise it right away, reaping at $500 profit, or $5 x 100 shares (remember that each options contract represents 100 shares). That's what is known as "in the money."

However, if you buy a call option for XYZ with a strike price of $45 and the current market value is only $40, there is no intrinsic value. That is known as being  "out of the money" or "under water."

This is where the second component of an option comes into play, which is how long the contract is good for.

Time Value

Even if your options contract is "out of the money," it eventually might have some value if there is a significant change in the asset's market price. That's what is known as the "time value" of the contract. It's whatever an investor is willing to pay above the contract's intrinsic value in the hope the investment will pay off eventually.

Say you buy the call option on XYZ with a strike price of $45 and the stock immediately plunges from $45 to $40. You may be underwater now, but in 30 to 60 days that stock might be back up to $50, which would give you a profit of $5 a share. Part of the pricing of the option is your bet that the stock will pay off over time.

So if you bought a call option for $45 and it had an intrinsic value of $5 (the stock was selling at $50), you might be willing to pay an extra $2.50 to hold onto that contract if thought the price would go up even more. That would make the option's premium, or price, $7.50 ($5 intrinsic value + $2.50 time value = $7.50 premium).

It's important to note that the option's premium is constantly changing depending on the price of the underlying stock and the amount of time left in the contract. The more an options contract is "in the money," the more its premium rises. By the same token, if the option loses some of its intrinsic value, or is "out of the money," the premium will fall as well.

The amount of time left in the contract also affects its price. The closer the contract is to its expiration date, the less value it has and the premium will fall.

Measuring Volatility

While all options tend to decline in worth as the expiration nears, the pace at which they do so can vary considerably. This “time decay” factor is a major determinant of the contract’s time value.

In the case of a steady, blue-chip stock, you’re probably not going to pay a large sum for either a call or a put in the 30- to 60-day window before its expiration. Naturally, the chance of the stock rising or falling momentously is limited during this relatively short period. Consequently, its time value will taper off well ahead of expiry.

Option premiums for somewhat erratic securities – promising technology stocks, for example – tend to decay more slowly. In this scenario, the odds of an “out of the money” option reaching the strike price is substantially higher, so the option holds its value quite a bit longer.

Because time value varies so much from one asset to the next, option traders like to get a sense of the stock’s volatility before placing a bet. One of the common ways to do this is by looking at the equity’s standard deviation. Based on historical data, the standard deviation measures the degree of movement, either up and down, in relation to the mean price. A lower number indicates a relatively stable stock – one that will usually command a smaller options premium.  

Another way to gauge volatility is by comparing the stock’s fluctuations to those of the stock market as a whole by finding its “beta.” A beta above 1 represents an equity that tends to rise and fall more than the S&P 500 (or another broad index). This propensity to jump in price means that any accompanying options will usually have a higher price tag. An equity with a beta less than 1 is comparatively stable and thus likely to have a smaller option premium.

These yardsticks are by no means perfect. The past performance of a stock doesn’t always predict future results. In addition, significant, one-time events have a way of making certain stocks look more unpredictable than they really are. But when it comes to getting a general sense of how stable a company is, they can be very useful.

The Bottom Line

Options can be a rewarding investment tool for the seasoned investor, though they do carry risks. Obtaining a better understanding of different pricing factors, including the volatility of the underlying asset, can increase the odds that they’ll pay off over the long term.

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