In the first instance, Options Domination is using Binary Options in Currency Pairs so we don’t really need to understand all the full working detail of Share Options. But at a later date we may well be offered a more comprehensive opportunity. So that you understand how they work, let’s consider a fictional company called The Sunrise Rum Company.
On May 1st the share price of The Sunrise Rum Co. is £57. The cost of buying a June60 Call is £3.15 (this indicates that the expiration date is the 3rd Friday in June and that the strike price is £60). As our option is for 100 shares, the total cost of the contract is 100 x £3.15, i.e. £315. (This does not take into account the cost of commission.)
Having a strike price of £60 means that the shares must rise above £60 each, before the Call Option is worth anything. And as the contract is £3.15 per share, the break-even point is in reality £63.15.
With the share price at £57 and the strike price at £60, you’re already down £315 (100 x £3.15).
Let’s suppose that by May 21st the share price has increased to £68. The Options contract has also increased in value to £7.25 per share and so is now worth £725. Subtract what you paid for the contract and you just doubled your money in 3 weeks… with a profit of £410 (7.25 – £3.15) x 100.
Now you could sell your Options and take profits (also known as “closing your position”). Or you may think that the share value will continue to rise.
Let’s say you let it ride.
By the time we get to the expiry date the share price has dropped back to £59. As the strike price was £60 and there is no time left, the contract is worth nothing.
The value of our contract went as high as £725 and we could have “closed out” at any time before the expiry date. This is often referred to as “leverage“.
Trading Out vs. Exercise
So far we’ve talked about the right to buy or the right to sell (i.e. to exercise) our option. But in reality a large majority of options are not actually exercised.
In the above example you could have exercised at £60 and then sold the shares back into the market at £68, so making a profit of £8 per share (not including the commission paid). Or you might keep the shares, knowing that you bought at a discount to the present value.
The large majority of traders, however, “close out” (sell) their position and take profits when they can. In other words, the holders sell their Options in the market and writers buy back their positions to close.
About 10% of Options are exercised, 30% expire worthless and 60% are closed out, according to the Chicago Board Options Exchange.
Intrinsic Value and Time Value
- Intrinsic Value is the “amount in the money” – which for a “Call Option” is when the value of the share equals the strike price
- Time Value is the possibility of the Option increasing in value
So we could think of our Option Premium as being £7 (Intrinsic Value) + £0.25 (Time Value) = £7.25. In reality Options almost always trade above Intrinsic Value.
N.B. The figures shown in the above are only for guide purposes to demonstrate how Options work.
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