In order to fully understand the basic principles of options, you must be sure to know the differences between the three frequently used terms and key parameters for every option. All three are prices, but their meanings are very different. These three kinds of prices are:
- Strike price of the option
- Market price of the option (also called option premium)
- Market price of the option’s underlying stock (or other underlying asset)
Option’s Strike Price
For example, you may own a call option on Microsoft stock with the strike price of 20 dollars. This is the characteristic of the option. Whatever happens in the markets, the strike price of this option will always be 20. Microsoft stock can go up to 100 or down to zero, but the strike price of this option you have will always remain at 20 dollars. Strike price is fixed throughout the whole life of an option.
If you exercise your Microsoft option, you will buy Microsoft stock for the strike price, i.e. for 20 dollars. Even when the stock would be trading at 100 or at 15 or at 1 dollar, the price for which you buy when you exercise this option is 20 (of course it does not make sense for you to exercise the option if the stock is at 15, as the option would be out of the money, and you better buy the stock in the stock market for 15 rather than for 20 using your option).
Option’s Market Price
Unlike strike price, the market price of an option does change during the option’s life. It is not fixed as a permanent characteristic of the option, but it is determined in the market by the interaction of supply and demand for the particular option in the same way as market prices for other securities are determined in other markets.
The market price of the option is the price you pay when you buy the option and the price you get when you sell the option.
The market price of the option consists of two parts, intrinsic value and time value. Intrinsic value represents the extent to which your option’s exercise price (the strike price) would be better than the market price of the underlying security. Time value represents the benefit of having the choice of exercising or not for a period of time. In general the longer the time period, the higher the time value (other things being equal). Both intrinsic and time value can be zero – when both are zero at the same time, the option is worthless.
Market Price of the Underlying
The market price (or spot price) of the underlying security is independent of the option. It is the price of Microsoft stock in the stock market in the example above. It is determined by supply and demand for the Microsoft stock itself (the underlying asset, not the option).
But the market price of the underlying directly implies the intrinsic value of the option through its relationship with the option’s fixed strike price. Therefore, it influences the market price of the option.
How They Are Related – Summary
Option’s strike price is fixed. Option’s market price moves according to the external conditions which influence the supply and demand for the option. One of the most important among the external conditions is the relation between the option’s strike price and the market price of the underlying.
As the strike price is fixed, we can say that the market price of the underlying is probably the most important determinant of an option’s market price (but not the only one). Remember that options are derivative securities and by definition the price of a derivative security is derived from the price of its underlying.
The extent to which an option’s market price depends on the market price of its underlying is measured by some of the well known Greek letters, namely delta and gamma.