Premium and Parity
- Date: 2007-07-02 - Word Count: 532
Share This!
Premium
Premium is the total amount of money (price) you pay for an option. So, if the Microsoft (MSFT) May 65 calls cost you $1.50 then the $1.50 is the amount of the premium of the option.
The total price of an option (premium) consists of two components. Those two components are intrinsic value and extrinsic value.
Intrinsic value, also called parity, is the amount by which an option is in the money. In the case of a call, the intrinsic value is equal to the present stock price minus the strike price. In the case of a put, the intrinsic value is equal to the strike price minus the present stock price. Only in-the-money options have intrinsic value. Out-of-the-money options have no intrinsic value.
For example, with MSFT trading at $65.00, the MSFT January 60 calls will have $5.00 of intrinsic value. If the MSFT January 60 calls were trading at $5.70, then $5.00 of that premium would be intrinsic value.
At the same time, the MSFT January 70 put will also have $5.00 of intrinsic value. So, if the MSFT January 70 puts were trading for $5.70, then $5.00 of that premium would be intrinsic value.
Extrinsic value is defined as the price of an option less its intrinsic value. In the case of out-of-the-money options, the option's entire price consists only of extrinsic value. Extrinsic value is made up of several components, with the largest being volatility.
In the examples above, if the MSFT January 60 calls were trading at $5.70 and $5.00 of that was intrinsic value, then the remainder ($.70) is extrinsic value. The same also holds true for the January 70 puts. If they were trading at $5.70 and $5.00 of that was intrinsic value, then the rest ($.70) is extrinsic value.
Parity
Parity - When we discuss parity in terms of options, we say that parity is the amount by which an option is in the money. Parity refers to the option trading in unison with the stock. This also means that parity and intrinsic value are closely related. When we say that an option is trading at parity, we mean that the option's premium consists of only its intrinsic value.
For example, if Microsoft was trading at $53.00 and the January 50 calls were trading at $3.00, then the January 50 calls are said to be trading at parity. Under the same guidelines, the January 45 call would be trading at parity if they were trading at $8.00. So, parity for the January 50 calls is $3.00 while parity for the January 45 calls is $8.00
Now if these calls were trading for more than parity, the amount (in dollars) over parity is called 'premium over parity.' Thus, the term 'premium over parity' is synonymous with extrinsic value, which was discussed above.
If the stock is trading at $53.00 and the January 50 calls are trading at $3.50 then we would say that the calls are trading at $0.50 over parity. The $0.50 represents the premium over parity that is also the amount of extrinsic value. The $3.00 is the amount of intrinsic value or parity.
The term time decay is defined as the rate by which an options extrinsic value decays over the life of the contract.
Premium is the total amount of money (price) you pay for an option. So, if the Microsoft (MSFT) May 65 calls cost you $1.50 then the $1.50 is the amount of the premium of the option.
The total price of an option (premium) consists of two components. Those two components are intrinsic value and extrinsic value.
Intrinsic value, also called parity, is the amount by which an option is in the money. In the case of a call, the intrinsic value is equal to the present stock price minus the strike price. In the case of a put, the intrinsic value is equal to the strike price minus the present stock price. Only in-the-money options have intrinsic value. Out-of-the-money options have no intrinsic value.
For example, with MSFT trading at $65.00, the MSFT January 60 calls will have $5.00 of intrinsic value. If the MSFT January 60 calls were trading at $5.70, then $5.00 of that premium would be intrinsic value.
At the same time, the MSFT January 70 put will also have $5.00 of intrinsic value. So, if the MSFT January 70 puts were trading for $5.70, then $5.00 of that premium would be intrinsic value.
Extrinsic value is defined as the price of an option less its intrinsic value. In the case of out-of-the-money options, the option's entire price consists only of extrinsic value. Extrinsic value is made up of several components, with the largest being volatility.
In the examples above, if the MSFT January 60 calls were trading at $5.70 and $5.00 of that was intrinsic value, then the remainder ($.70) is extrinsic value. The same also holds true for the January 70 puts. If they were trading at $5.70 and $5.00 of that was intrinsic value, then the rest ($.70) is extrinsic value.
Parity
Parity - When we discuss parity in terms of options, we say that parity is the amount by which an option is in the money. Parity refers to the option trading in unison with the stock. This also means that parity and intrinsic value are closely related. When we say that an option is trading at parity, we mean that the option's premium consists of only its intrinsic value.
For example, if Microsoft was trading at $53.00 and the January 50 calls were trading at $3.00, then the January 50 calls are said to be trading at parity. Under the same guidelines, the January 45 call would be trading at parity if they were trading at $8.00. So, parity for the January 50 calls is $3.00 while parity for the January 45 calls is $8.00
Now if these calls were trading for more than parity, the amount (in dollars) over parity is called 'premium over parity.' Thus, the term 'premium over parity' is synonymous with extrinsic value, which was discussed above.
If the stock is trading at $53.00 and the January 50 calls are trading at $3.50 then we would say that the calls are trading at $0.50 over parity. The $0.50 represents the premium over parity that is also the amount of extrinsic value. The $3.00 is the amount of intrinsic value or parity.
The term time decay is defined as the rate by which an options extrinsic value decays over the life of the contract.
Related Tags: stock option trading, online option trading, home study course, options trading school, option trading school, online stock option trading, online trading options, traders and investors, options home study, trading options made
This Article Provided By The Options University: Options Trading Strategies For Safer Investing and Consistent Profits. Discover how to protect your investments with the leveraged power of options. Step-by-step video tutorials, articles, free and premium trading content can be found at: http://www.TheOptionsUniversity.com Your Article Search Directory : Find in Articles
Recent articles in this category:
- The Secrets to Getting Low Down Payment Car Insurance
Upon purchase of a new car, there is almost always a requirement to buy an auto insurance policy as - The Wisdom Behind Auto Insurance Comparison Quotes
No one in his right mind would not go for a good deal. In fact, everyone is out on their feet and ru - The Benefits of Auto Insurance Comparisons Florida
Insurance can be expensive. This is something everyone knows about especially in the sunny state of - Auto Insurance Florida: The No-Fault Policy
There are different kinds of car insurance offered by a wide range of providers today. Different sta - Finding the Cheapest Auto Insurance Companies
Everyone is asking and searching for the cheapest auto insurance companies available today. Consider - How do You Compare Private Health Insurance Cover in Australia?
Deciding what is the best and most affordable private health insurance cover can be easy if you take - How Payment Protection Insurance Was Mis-Sold
For over six years the issue of Payment Protection Insurance (PPI) and how it was mis-sold to custom - Finding Quotes For Auto Insurance Online
One of the many concerns when you are shopping for auto insurance is being able to get access to quo - How You Can Find the Best Auto Insurance Online
When it comes to renewing your car insurance you are going to quickly discover that there are a numb - Guidelines For Searching For Auto Insurance Online
The internet can be a great source of discounts and values related to auto insurance. However, many
Most viewed articles in this category:
- Trading Forex With Pivot Points
Forex Pivot Point Trading are used today by Forex Traders and are calculated on the previous days mo - Where To Search For Free Grants
Where do you look for free grants? The search must be thorough or it could be an exercise in futilit - The Connection Between High Blood Pressure and Salt
We are a society of Salt Addicts. It cannot be denied. When you look at the things we do and the pla - Tips For Avoiding HYIP Scams
Before knowing about HYIP Scams, refer to the functioning of HYIP or "High Yield Investment Programs - Getting Credit After Bankruptcy
Consumers do not have to live sans credit following a bankruptcy. By following certain steps consume - Tips For Choosing A Credit Card
Are you looking for that perfect credit card? If so, you may be confused about what exactly to look - Cheap Car Insurance For Teens Online
Many elements determine a car insurance policy. Car insurance companies look at the person's age, hi - What Exactly Is Free Grant Money?
You can apply for free grant money from various government agencies. But where exactly does this mon - Small Business Owners Marketing and Customer Service
Marketing can be time-consuming, but it doesn't have to be hugely expensive now, thanks to the Inter - Apply Online For A Credit Card - How To Choose A Card?
The best type of credit card for you will be dependant on how you intend to use the credit card. Are