Thursday, September 3, 2015

Option Contracts - In the money and Intrinsic Value

Option contracts for the Series 3 exam. This post will discuss option contracts that are either in or out of the money. The Series 3 Licensing test will ask questions on this topic. The Series 7 exam will as well

in, at or out of the money

Call Options

A call option is purchased when a trader or investor anticipates the futures price to rise during the life of the contract.

A call option gives the holder the right to purchase the commodity at a specific price regardless of the price in the market. That price is called the strike price. The contract will cost a premium.

"in the money"


when the futures price, whether it's Gold or other commodity is higher than the strike price of the call option, that difference is the in the money amount. "in the money" does not mean profit. It could, but the in the money term is the difference only between the futures price in the market and the strike price. If a high premium was paid that exceeds that difference, the call is still in the money. If the option is in the money, the option is said to have "intrinsic value". So, for a call
the futures price minus the strike price is the intrinsic value.


"out of the money"

This is the opposite of in the money. For calls - since the purpose is the hope that the market will rise above the strike price, when it does not or fall below the strike price that difference would be the out of the money amount. You can profit several ways from a market decline (shorting the commodity, shorting the call, buying put options), but if you are long (buyer) of call options, a profit will only be there if the market rises. As with the in the money example, the premium does not play a role with in, at or out of the money. There is no intrinsic value for out of the money contracts. Regardless of the negative number, the Intrinsic Value will be ZERO.

"at the money"

When the commodity is the same price as the strike price, the call (or put for that matter) is considered "at the money".

These concepts all play into the marketabililty of the contract during it's life. Meaning, an option can be exercised, allowed to expire or they can be sold - traded at the current market price of the option. The is the sell side (bid) premium. If the investor feels the call option has little shot to recover it's profit possibility, he or she may want to trade out of it before it expires. Most options will decline in price as the expiration date nears.

All of these terms are tested on the Series 3 Exam, Series 7 Test or any NFA FINRA Exam where Options are part of the exam outline.

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