A simple guide to options premium — With example

Options Premium

Today I want to talk about options premium, what it is, and I’ll show you a very specific example.

Many people are struggling to understand how options premium work.

As you know, I have been selling puts recently during this the stock market crash and have been doing really well.

Now I want to show you exactly what I’m doing, and why I’m doing it.

Let’s get started.

 

SPCE Example

I want to use a specific example of SPCE, because that is an option that I’m currently trading.

And I want to show you exactly how it works.

Let me first bring up the chart of SPCE. It’s Virgin Galactic.

You can see right now, the stock is trading at $16.65, this is the current price.

Now, I want to do two things.

First of all, we want to consider call option with a strike price of $18, and I also want to show you a strike price of let’s do $15.

You see the $16.65, the current price. When we buy a call option for $18, it means that now we can buy this stock for $18.

Now, why would that make sense if it is trading at $16.65? Of course, it doesn’t make sense.

So this is why the real value of this option is $0, right? Because at this point, why would you buy a stock for $18 if you could buy it for $16.65?

Now a strike price of $15 is a different story here.

So a strike price of $15 means that we can buy this stock for $15 if we have a $15 call. So this means the real value here is $1.65.

Why?

Because we could buy the stock for $15 and then sell it right away for $16.65.

Let’s move on and look at the…

 

Current option prices in the market that are happening right now

Here we are looking at an option chain for SPCE.

So right now we see that the $15 call, that expires in 15 days from now, is trading at $3 times $3.20. Let’s just say the current price is $3.

What does this mean?

Why is this option trading higher than just the $1.65 right now?

Well, because over the next 15 days, the stock might move much higher.

So as you can see, there’s a difference, and the difference is what we call the time value.

So the time value is the difference between $3 and $1.65, so that’s $1.35.

 

What does this time value mean?

Well, this is where traders are expecting that this stock might move even higher over the next 15 days.

Now this premium, this time value, will disappear day by day. And we’ll talk about this in just a moment.

So as you can see, the $18 call is trading at $1.74 over $1.83. In order for us to make it easy, let’s say the current price is $1.80.

What does this mean?

Since there’s no real value in there at all, it means that the time value of this option is $1.80.

Now, just looking at these two options, which time value is higher?

Well, obviously, the $18 Call Option. The option that is out of the money, that has no real value yet.

Now I want to do it the other way around and show you a put option example so you know exactly why I like to sell premium.

 

Put Example

We’re using an example for a put. Again, we are drawing some basics here on the chart.

Right now we are trading at $16.65.

Now let’s take a look at two puts, one put of let’s say $18, and we will take a look at a put that is trading at $13 because that is the put that I currently have.

You saw previously that we can buy the stock. So call means that we can buy the stock at the strike price.

When we talk about puts, it means that we can sell the stock at the price.

If the stock is trading at $16.65, and we can sell it at $18, what is the real value of this option?

It doesn’t have real value, think about it. It’s trading at $16.65, and if we could sell it right now at a higher price of $18, our profit would be $1.35.

Making sense?

Now, also, for the $13 put, if the market is trading right now at $16.65 and we could sell the stock for $13, would that make sense?

No, we would lose money, so this is why here the real value is $0.

 

Let’s look at the current price and the time value.

Let’s jump onto the platform and take a look.

Now we are looking at an $18 put, and you see that right now the put is at $3.15 over $3.30. Now let’s just say the current price is $3.35 to make it easy.

So this means that the time value here is $2.

And now we’re also looking at the current price for the $13 put, let’s say it’s $0.75. $0.73 over $0.79, $0.75.

And since the real value is nothing, it means that the time value is $0.75.

Now here’s the deal with this time value. Let me just show it to you on this chart.

Here you see that the time value actually goes down over time. What you see here is the DTE, that’s the days to expiration, and this here is the dollar sign.

You see in the last 30 days this is when we see that the time value is decreasing quite quickly.

So this is when we talk about the time value, and this is exactly where right now I can make money when I’m selling options.

 

Recap

I know this is a very quick introduction, but it is super important that you understand that an option price always consists of two things.

The real value and the time value.

And when we are selling options, what we want to take advantage of is the time value.

I hope this helps you better understand what options premium is and when it makes sense to buy options and when it makes sense to sell options.