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Valuation of Options
Options valuation can be best
understood by separating the value of an option into two components: intrinsic value
and speculative value.
Intrinsic Value is the real,
non-inflated value of a security, often phrased "in the money". In stock
options, this value is always equal to the difference between the exercise (strike) price
of the option and the market value of the underlying stock, but can never be lower than
zero.
e.g. If you have an option to
buy a stock at 50 when this same stock trades on the open market at 55, the option has $5
of intrinsic value. Conversely, if you have an option to buy a stock at 50 when this
same stock trades on the open market at 45, the option simply has no, or zero, intrinsic
value.
Speculative Value is the
inflated, artificial portion of the option value built into the option's price based
solely on the belief that this option will have intrinsic value (be in the money) sometime
before the option expires. In stock options, this value is equal to the market value
of the option minus the intrinsic value of the option.
e.g. If you have an option to
buy a stock at 50 when this same stock trades on the open market at 55, the option has $5
of intrinsic value. If the market value of the option is 6 then the option has a
speculative value of $1 ($6 - $5).
Thus, the total market value of
an option contract can be characterized as equaling the sum of the intrinsic and the
speculative values.
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