Page 286

Premium

By now you probably have figured out that the fee we have been referring to in our example is actually part of the premium of the option. This part is known as the time value premium. The time value premium is not the price of the option, but the fee you pay for the right to lock in a price for the underlying stock. It is the effective price of the option. As you can see in some cases such as FAL, the time value premium ($1/8) does equal the price ($1/8). In other cases such as FAH the time value premium ($1) is lower than the price ($11). In all cases, the time value premium of an option is always less than or equal to the option's total premium, but never greater. This concept will become more clear in the following sections. In some cases, people (and some brokers) may refer to the time value premium as just premium. This could cause a bit of confusion in terms of whether the premium refers to the total price of the option or just its time value. By inspecting the option's terms this confusion can be easily cleared up. I like to use the term "price" when referring to the option's cost. An option's premium (be it its cost or its time value premium) is not part of an option's standard term. The standard terms of an option (e.g., strike price, expiration date, etc.) are always fixed, while an option's premium constantly changes depending on other factors. Hang in there, these concepts will become more clear as we go further.

In/Out/At The Money

The FAJ option is referred to as at-the-money since its strike price equals the current stock price (both $50). The FAH option is referred to as in-the-money since its strike price is at a $10 advantage to the current stock price ($40 vs. $50). This option is said to be $10 in the money. Finally, the FAL option is called out-of-the-money since its strike price is at a $10 disadvantage to the current stock price ($60 vs. $50). This …