|
This is a level 1 question.
How do I compute the time value of LEAPS. I understand that the current risk-free interest rates have some bearing. Please explain. Formulas would be helpful.
Time value is very simple to calculate. For an in-the-money option, you can derive an option's time value by subtracting its intrinsic value from the current premium. The intrinsic value is the amount that the option is in the money. Since you're interested in LEAPS, let's use one as an example. Suppose that:
- a stock is trading at 58.50
- a LEAP on the stock, a call with a strike price of 50, is asked at 17.25
The LEAP has an intrinsic value of 8.50 (58.50 minus 50), and its time value is 8.75 (17.25 minus 8.50). Note that since this option has a long life, more than half of its price is attributable to time value.
Out-of-the-money options don't have intrinsic value. Therefore, their premium is made up entirely of time value. For example, if a call on the same equity has a strike price of 70 and is currently asked at 8, all of that is time value.
If you would like to predict how time decay will affect the price of an option, you can use the option's theta. Theta defines the loss in value an option will experience as time passes and is usually expressed on a per day basis. It's important to realize that theta is non-linear such that it accelerates as the option nears expiration. You can obtain an option's theta at www.phlx.com.
The October 60 call on AXP has a theta of –0.04. In other words, the option will lose about four cents per day in time value, assuming that the stock price and the volatility remain constant.
The current risk-free rate is a variable in calculating the theoretical price of an option, but it has nothing to do with time value.
|
Question Level Key
Level One--Basic Jargon, Definitions, Basic Mechanics of Trading.
Level Two--Introductory Points, Practical Points and Simple Strategies
Level Three--More Advanced Strategies and Repairs
Level Four--Risk Management, Psychology, and How Best to Evaluate Things.
Level Five--High end questions concerning Portfolio Analysis, Managing a Portfolio
of Options, Option Pricing Models, and Nuances of Trading. Included could be a variety of
other topics.
|
Do you have questions about options trading?
We've got answers.The idea here is that you submit any questions you have
regarding options trading, and each trading day we will select one question to answer from
all those submitted. Then, we'll archive each question we answer so that over time,
the Q&A Archive will grow into an extensive library of educational material.
The key component to this equation is that we need your questions. They can be as
simple or as complex as you like, and we will try to answer a fair sampling on both ends
of that spectrum.
|
Today's Most Popular Stories
Read
Emailed
Editor's Pick
|
