Understanding the Value of Options: An Investor's Guide

Estimated read time: 5 minutes

Options are an often overlooked way to grow a financial portfolio. They are seen as complicated, overinvolved, and speculative. While the latter is not wrong, trading options does not have to be a complicated process left for only the most involved investors.

Options are great ways to enhance the gains you make from investments. They allow you to buy a contract that allows you to either buy or sell shares in a security at a particular price within a set timeframe. As such, options operate as part of the derivatives market.

Based on speculation about the future value of a stock, investors who trade in options generally do not look to be active shareholders. So where do options gain their value and why should investors pay attention to them? Read on to find out why options are among the best investing strategies out there.

The intrinsic value and time value of options are why some are able to make such big profits on options.

Types of Options

There are two types of options, call options and put options. Both are based on the above principle of securing a fixed price for a share within a particular time frame.

Call options secure a set buying price for a stock within a contract window. In the case of buying a call option, an investor is betting the price of a stock will increase by a particular date. If the stock does so, the investor will exercise the option at the purchased strike price, immediately selling the shares for a profit or directly selling the call option for a profit.

Put options secure a set selling price for a stock within a contract window. They are mainly used as somewhat of an insurance policy in uncertain markets. When a shareholder owns a stock, they understand market volatility.

Put options allow shareholders to mitigate risks of complete market collapse by allowing them to guarantee a particular selling price for a share in a particular window of time, regardless how far a stock may fall.

Both types of options carry with them a premium. A premium is assessed upon purchasing an option and is charged regardless of whether an option is executed in a timeframe or not. It is the only amount an investor can lose when trading in options.

Why Use Options?

Though options are seen as complicated, they are among the top choices for those seeking to minimize risk while being active traders. Some of the most active traders and successful investors use options in their portfolio. Warren Buffett is well-known for his acumen in buying calls and puts.

Options are great for portfolios because of the protection they offer and ways investors can profit. Regardless of the type of market (bull, bear) buying an option can still turn profits. They provide a sort of insurance against speculative markets, stocks, and industries and are a fantastic resource for investors who are active buyers-and-sellers.

Trading options is also great for both long term and short term stock market plays. For those interested in long term options they can establish long-lasting contracts based on speculation about an up-and-coming stock and outside influences. Though they expect it to perform well, market uncertainties don't allow an investor to want to hold outright shares in the companyThat is where the options come in. Conversely, a shareholder in a stock who sees value in holding position can protect against market collapse by purchasing a put option.

For short term players in the market options are also lucrative. They allow investors to go with the ebb-and-flow of market trends and make quick profits without attaching themselves to particular securities. Money can be expanded greatly overnight in this regard.

Option Pricing: The Basics

With options being so lucrative and their value clear, many may wonder how they are priced. What causes a call option to be assigned a particular value, and what causes a put option to do the same? To turn a profit with options necessitates understanding option pricing.

Factors influencing the pricing of an option include the current stock price, time value (time to expiration), the intrinsic value (to be discussed further below), the state of the current market, and cash dividends. These factors are combined through a number of models to assess an option's fair market value.

To begin, as a stock price increases and decreases, so will a call option. Options and their values are largely attached to the same pattern of a stock. As one rises, so does the other (and vice versa).

The intrinsic value is the value of an option on any given date should the option be exercised at that point in time. In the case of call options it is the current stock price minus the strike price of the option. In the case of put options it is the strike price of the option minus the current stock price.

The time value of an option is the premium minus its intrinsic value. It takes into account how long until a contract expires and the premium paid at the start of a contract. The longer amount of time left in the contract, the more potential there is for an option to profit. This means that as time decreases so does the time value of an option. There is no longer as much opportunity for profit.

Option Value: It's Intrinsic

As illustrated above, much of the value in an option is intrinsic. Both call and put options require consistent monitoring of value, especially for long play options that have contracts expiring in the far-off future. The longer the contract, the more potential there is for an option to be valuable.

The intrinsic value and time value of options are why some are able to make such big profits on options. Top investors know how to value an option and weigh all aspects of options contracts when deciding whether to exercise an option or not.

Take, for instance, an investor who purchased an option, and one day, with 60 days remaining on the contract, sees profit in the option skyrocket. Will they exercise an option immediately or wait another 60 days? That decision will be ultimately left up to them, but it is an important one to understand.

Now, let's take that same investor and say they only have 2 days left in the option. The odds of a larger profit are significantly less, so they may very well exercise the option right away (and would be smart to do so).

Options, as you can see, are an outstanding way to make a profit in investing. Think of options as those looking for the best deals. You put a premium on the time you spend but that premium can have significant payoffs should you put in the time and work necessary to find the best deal.