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Terms used in pricing options

When considering options it is important to understand the terms used.  

An option's premium is the only element of the option not specified by ASX. It is influenced by a number of factors, including the price and volatility of the underlying stock, the option's exercise price and the time until expiry. An option's premium can be broken into two parts, intrinsic value, and time value:

Premium = intrinsic value + time value

Intrinsic value is the difference between the option's exercise price and the current share price. It cannot be less than zero. An option invariably trades at no less than intrinsic value. Call options have intrinsic value if the share price is above the exercise price. Put options have intrinsic value if the share price is below the exercise price.

An option has intrinsic value if exercising the option would result in you buying or selling the shares at a price better than the current share price.

Before expiry, an option often trades for more than its intrinsic value. The part of the premium over and above its intrinsic value is its time value. Shares do not have a time value component, as they have no expiry date. Options, on the other hand, are a wasting asset, and an important part of their value is the time remaining in the option's life.

There is a 'shorthand' commonly used to refer to options, according to the option's strike price and the current share price. It's worth being familiar with these terms:

In the money (ITM): Share price is above the strike price of a call, or below the strike price of a put. 

Out of the money (OTM): Share price is below the strike price of a call, or above the strike price of a put.

At the money (ATM): Share price is the same as, or close to, the strike price.

What affects an option’s time value?

Time to expiry

The longer the time to expiry, the greater an option's time value (both calls and puts), all else equal.

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The more volatile the stock, the higher the option's premium, all else equal.

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If the stock goes ex-dividend during the option's life, option pricing is usually affected.

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Interest rates

Increases in interest rates can lead to higher call premiums and lower put premiums, all else being equal.

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ASX Online Courses

Both courses have 10 modules with each module taking 20-25 minutes to complete

Cost of trading in options

When you trade an option, the value of the trade is generally lower than if you were to trade the same number of the underlying shares. Because of this, options are generally a cost efficient way to trade your view of a stock. There are three types of costs to consider.

Brokerage varies and can be:

  • a flat fee, charged on a per transaction basis
  • on a percentage basis i.e. a percentage of the gross value of the order, or
  • a combination of these two, such as a flat fee for orders up to a certain dollar value, and then a percentage charge thereafter.

ASX Clear charges fees, including:

  • a transaction fee for share option contracts 
  • exercise fees for share and index options
  • an assignment fee, if you are assigned on an option position, and
  • a registration fee for index options.

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No stamp duty is payable on option transactions or securities transactions arising from options exercise.