Determining The Stock Option Values

The value of the stock option is derived from an actual stock or equity. The price movement of the underlying stock makes the value of the optionincrease or decrease. This price movement is the intrinsic value, or fair value,of the stock. In addition to their intrinsic values, options also have time values, whichreflect what the holder is willing to pay for an option in anticipation of astock price increase before the expiration date. Most options are for ninemonths, and the option can be bought or sold many times during this timeperiod. As an option gets closer to the expiration date, the value of theoption can decrease, increase, or remain unchanged, depending upon thecurrent value of the underlying stock. Just before the expiration date, thetime value becomes zero.The Chicago Board Options Exchange (CBOE; www.cboe.com) provides manymaterials for novices to check out, including an excellent introduction tooptions, profitable trading strategies, answers to frequently asked questions,a glossary of option terms, and a schedule of educational events and seminars for beginning investors. To access these materials, go to the CBOE homepage and click Learning Center. Investors often use stock options to hedge their bets or to gamble on thefuture.

Investors need to know four things to make a good investment decision:

Name of the underlying stock: The name of the underlying stock or equity. The name could be a company that your analysis shows might soon rapidly increase — a company stock that you want to purchase but can’t afford. You might want to select stock options for a company in which you already own stock to protect your portfolio from a market-driven decline in price.

Strike or exercise price: The stated price per share for which the under lying security can be purchased (in the case of a call) or sold (in the case of a put) when you exercise the option contract. Option contracts are usually for 100 shares. The higher the exercise price, the lower the value of the call option. (See the section “Types of option contracts” for more on calls and puts.)

Expiration date: Option contracts are for three, six, or nine months (or remaining fractions thereof) on three calendar cycles. Cycle 1 is January/ April/July/October; Cycle 2 is February/May/August/ November; and Cycle 3 is March/June/September/December. As the option approaches the expiration date, the value of the option decreases. Options usually expire at midnight EST on the third Friday of the expiration month.

The premium paid for the option, plus the broker’s commission: The price of the option contract is the premium. All things being equal, the longer the time period of the option, the higher the premium. The com mission is the amount that you, as the investor, pay the brokerage for executing the transaction of purchasing the option contract. optionsXpress (www.optionsxpress.com/paper_trading.asp) offers virtual trading, which is a practical method of gaining experience with options trading without risking any of your precious capital. All your trades are tracked on paper only. Virtual trading is useful because you make decisions and experience the results of those decisions in real time. Virtual trading is available to individuals who open an optionsXpress trading account. No mini mum amount is required to open a cash account; there is a $2,000 minimum to maintain a margin account.

Taking a closer look at options

Using the business school approved intrinsic value method, a stock option’s value is equal to the difference between the option strike price and the fair market value of the stock. For example, suppose that you’re granted an option to purchase 100 shares of the company’s stock for $10 each. The stock sells for $54. The intrinsic value of the option is $44 because $54 – $10 = $44. The intrinsic value is a positive number, so the option is in-the-money. However, this formula doesn’t consider brokerage fees or interest fees on a margin loan from your broker, which can reduce the actual gain you realize. Keep in mind that the intrinsic value method also doesn’t consider that option holders have the right to use their options at some time in the future, which can result in a greater profit or loss if the trading price of the underlying stock falls.

myStockOptions.com (www.mystockoptions.com), with your free registra tion, provides step-by-step instructions that help you to determine exactly how much money you’ll take home (after taxes) if you exercise your stock option today. Use the Quick Take Calculator by entering the number of shares in your stock option grant, the exercise price, and the company’s current stock price and then click Calculate. What makes this calculator unique is that it applies taxes to your transaction. You can even use the myStockOptions modeling tool to perform a what-if analysis. For example, enter a percentage increase or decrease under the What If Company Stock Price to determine an ideal selling price.