Understanding American Style Options Contract Values

In the first part of this section, we explained time value. We also explained that if a stock is “out of the money” it can be affordable to purchase since it will be sold at a discount. Then again, however, this discount comes at a price since you are taking on more risk with the purchase. The premium can go down and the option might sell for less than what you bought it at, making you lose money in the investment overall.

You are now dealing with a game of calculated risks that are depending upon a certain date in the marketplace to fix your options contract. If you have an option that has intrinsic value, it will be “in the money.” The more “in the money” it is, the more the price will tend to move similar to that of the asset itself.

Even if you have a small gain in the price, you can see a large profit based on the number of shares you got in the contract. Of course, the reverse is also true and you can lose a lot this way, too, but if you lose you can chalk it up to counter any capital gains tax you might have gotten.

If you use your options in an American style, you will be able to exercise your option anytime before the expiration. European style, on the other hand, means that you exercise your option on the actual expiration date itself.

Traders who are selling their options aren’t doing it so they can just give away their money. You can look at any selling opportunity as a way to leverage immediate arbitrage. Arbitage is the buying and selling quickly of assets in two different markets in order to take advantage of the price differences and to reap fast, quick profits.

Arbitage, however, will tend to push the prices in a balanced, break-even situation.

In this way, the time value will become the biggest factor for profit for the options investor. The time value will have two influences – the time left until the expiration date and the current difference between the strike price and the current market price.

Two options with two totally different strike prices (but have the same expiration date) will be seen as having two different time values based on their strike prices. Two options with the same strike price but different expiration dates can also have two different time values. The premium will be influenced by the size of these differences for both options.

If the asset price doesn’t change and the strike price of the different options is the same, the remaining variable that is left will be the amount of time until expiration. If you look at a chart that shoes options premium versus the time until its expiration, you will see a declining line. The closer the option gets to its expiration, the less time value it will have.

As expiration dates near, the premium prices will fall.