Mako Financial Markets

OPTIONS OVERVIEW

In, at, and out-of-the-money

An option is ‘in-the-money’ when there would be profit in exercising it immediately and out-of the-money when it would be worthless if exercised immediately. The option with the strike price closest to the prevailing market price of the underlying product, is at-the-money.

Intrinsic and time value

The option price (premium) can be considered as the sum of two specific elements: intrinsic value and time value. The intrinsic value is the amount an option holder can realise by exercising the option immediately. Intrinsic value is always positive or zero. The time value of an option is the value over and above intrinsic value that the market places on the option. It can be considered as the value of the continuing exposure to the movement in the underlying product price that the option provides. The price that the market puts on this time value depends on a number of factors: time to expiry, volatility of the underlying product price, risk free interest rate and expected dividends.

Time to expiry

Time has value, since the longer the option has to go until expiry, the more opportunity there is for the underlying price to move to a level such that the option becomes in-the-money. Generally, the longer the time to expiry, the higher the option’s time value. As expiry approaches, an option’s value tends to zero, and the rate of time decay increases.

Volatility

The volatility of an option is a measure of the price movements of the underlying instrument of that option. The more volatile the underlying instrument, the greater the time value of the option will be and the greater will be the uncertainty faced by the option seller. Thus the option seller will charge a higher premium to compensate. Option prices increase as volatility rises and decrease as volatility falls.

Option sensitivities "the Greeks"

Delta: measures the change in the option price for a given change in the price of the underlying and thus allows exposure to the underlying to be determined. The delta is between 0 and +1 for calls and between 0 and -1 for puts.
Gamma: measures the change in delta for a given change in the underlying
Theta: measures the effect of time decay on an option. As time passes, options will lose time value and the theta indicates the extent of this decay. Both call and put options are wasting assets and therefore have a negative theta.
Vega: measures the effect that a change in implied volatility has on an option’s price. Both calls and puts will tend to increase in value as volatility increases, as this raises the probability that the option will move in-the-money. Both calls and puts will thus possess a positive vega.

*These descriptions are provided for information purposes only and we do not guarantee accuracy of the data.