By Matt Hibbard – Port Phillip Insider (Australia) –
Every so often throughout the year, the markets experience some periods of trading that really ramp up option prices. Higher option prices mean bigger premiums! It happens only a few times a year. But when these windows of opportunity open, my income strategy becomes even more powerful, sometimes doubling or tripling the amount of income you can receive from each new trade.
To understand how these windows of opportunity work, you need to know a bit more about how options are priced.
Where your premiums come from
Options prices are based on three things.
The first is time value. The longer the time before an option expires, the higher the option’s value will be. The reason is simple: If you’re the buyer of an option, the longer window of time you have to see if your trade will work out, the more you’re going to pay for the privilege.
Meanwhile, options are worthless at expiry. As an option contract moves along day by day towards its expiry date, the option naturally loses time value until it’s all gone.
The second component of an option’s price is intrinsic value. Intrinsic value is when the option buyer could exercise their option and immediately make a profit.
For example, if a stock is trading at $20 and a put option contract has a strike price of $22 — giving the put buyer the right to sell the stock at $22 — the put has $2 of intrinsic value. If you exercised the put immediately, you’d have a $2 profit to show for it.