CALCULATIONS
Derivatives - In this case an option to buy something comprises of 2 factors that make up it's price. Intrinsic Value and Time
Intrinsic Value - Otherwise known as "In the Money" value. If you were to exercise the option today, how much profit would you make.
Example - If a price of the hockey ticket is going for $100 and you have the option to buy it for $80, the intrinsic value of
option would be $20.
- Intrinsic value never goes below 0. Example. If the hockey ticket was going for $60 and you have the option to
buy it for $80, the intrinsic value would be 0, not -20.
Time Value - The value associated with the amount of time left for the underlying asset to go up. In the house example, there is still 6
years left on the house option to reach the $700,000 or higher. There is a value associated with that time.
- The less time you have, the lower the time value becomes.
- Example. If today the value of houses are $640,000. That means your option has no intrinsic value (because its under
$700,000) however the option wouldn't trade for $0. Whatever the option trades for must be it's time value.
Click on the following sheet for some practice questions.
Intrinsic Value - Otherwise known as "In the Money" value. If you were to exercise the option today, how much profit would you make.
Example - If a price of the hockey ticket is going for $100 and you have the option to buy it for $80, the intrinsic value of
option would be $20.
- Intrinsic value never goes below 0. Example. If the hockey ticket was going for $60 and you have the option to
buy it for $80, the intrinsic value would be 0, not -20.
Time Value - The value associated with the amount of time left for the underlying asset to go up. In the house example, there is still 6
years left on the house option to reach the $700,000 or higher. There is a value associated with that time.
- The less time you have, the lower the time value becomes.
- Example. If today the value of houses are $640,000. That means your option has no intrinsic value (because its under
$700,000) however the option wouldn't trade for $0. Whatever the option trades for must be it's time value.
Click on the following sheet for some practice questions.
option_practice.pdf | |
File Size: | 15 kb |
File Type: |
Percentage gained/lost Formula
Remember the formula we used for calculated the percentage gained/lost from a stock
% gained = [(sold price - buy price) / buy price] x 100
we will use the same formula but now just use the option price instead of the stock price
% gained = [(option price - original option price) / original option price] x 100
% gained = [(sold price - buy price) / buy price] x 100
we will use the same formula but now just use the option price instead of the stock price
% gained = [(option price - original option price) / original option price] x 100
Hockey Ticket Example
Assume you bought the option for $2. Also assume the price of the tickets went to $120. What percentage would your investment make.
Intrinsic value of the option at the day of the game would be $40 (120 - 80)
Using the formula's above % gain = (40 - 2) / 2 x 100 = 1900% or 19 times your money
However if the price of the hockey ticket fell below $80.00 you would lose 100% of your money at the time of the game. ($2)
Assume you bought the option for $2. Also assume the price of the tickets went to $120. What percentage would your investment make.
Intrinsic value of the option at the day of the game would be $40 (120 - 80)
Using the formula's above % gain = (40 - 2) / 2 x 100 = 1900% or 19 times your money
However if the price of the hockey ticket fell below $80.00 you would lose 100% of your money at the time of the game. ($2)
Real Estate Example
Assume you purchased the option for $5000. Also assume the price of houses went to $840,000 by 2020.
Intrinsic value of the option would now be $140,000 ( 840,000 - 700,000)
% gain = (140,000 - 5000) / 5000 = 2,700% or 27 times
However if the price of houses didn't get to $700,000 you would lose all your money invested (100% or $5,000)
Assume you purchased the option for $5000. Also assume the price of houses went to $840,000 by 2020.
Intrinsic value of the option would now be $140,000 ( 840,000 - 700,000)
% gain = (140,000 - 5000) / 5000 = 2,700% or 27 times
However if the price of houses didn't get to $700,000 you would lose all your money invested (100% or $5,000)
In both cases you could of made a lot of money or lose everything. That's why derivatives (options) are exciting. This also helps you figure out what you would pay for each option. How much are you willing to pay to make a lot or lose everything. Go to our online discussion this week under " Option Prices - 2nd discussion" and comment on what prices you think the options should be worth now with the knowledge of how much money you could make or lose.