Forex Investment and Currency Trading

In order to be able to come to valuations for options, use is made of, among other things, certain static and dynamic reference values.

Dynamic reference values measure changes in the price of the option on the basis of variable parameters such as volatility or term. With their help, it is possible to estimate the future performance of options from today’s perspective. To allow this to be determined accurately enough, complex option valuation models are required.

The static reference values include:

• Intrinsic value
• Time value
• Premium
• Break-even point
• Leverage

These reference values offer you, as an investor, assistance in making an investment decision involving the choice of an option and its purchase or sale.

Important note: Such reference values should only be used to compare options if the options involve the same set of characteristics. Even slight variations in such characteristics (underlying asset, term, strike price, type of option i.e. call or put) can have a significant effect on the reference values and thus reduce their meaningfulness for the purpose of a comparison.

Intrinsic value
The intrinsic value is the difference between the strike price and the market price of the underlying asset, multiplied by the option ratio expressed as a fraction (e.g. 0.5 in the case of one share for two options).

“In the money”
An option has an intrinsic value if, when it is exercised, the current market price of the underlying asset lies – in the case of a call option – above, or – in the case of a put option – below, the strike price. In this case, the option is said to be “in the money”.

“At the money”
If the strike price and the current market price are identical, the option has no intrinsic value. In this case, the option is said to be “at the money”.

“Out of the money”
An option also has no intrinsic value if the current market price of the underlying asset lies below the strike price of the call or above the strike price of the put. In this case, the option is said to be “out of the money”.

Time Value
The time value of an option is calculated as the difference between its market price and its intrinsic value. If the option has no intrinsic value, the market price is derived entirely from its time value. In rare cases, an option may also be traded below its intrinsic value, i.e. with a negative time value.

The time value is the “uncertainty premium” which, among other things, reflects the probability of fluctuations in the price of the underlying asset until the maturity of the option.

The time value is essentially determined by the remaining term of the option and the volatility of the underlying asset (i.e. the frequency and intensity of price fluctuations during a particular period). That is, the shorter the time remaining until the expiry date and the lower the volatility of the underlying asset, the lower the time value, since the probability of a change in the price of the underlying asset decreases as the remaining term grows shorter. Because of the associated reduction in the buyer’s chances of making a profit, options with shorter remaining terms generally have lower time values than those with longer terms (assuming that the underlying asset and the strike price are the same).

Every option inevitably loses its time value until, by the end of the term, the time value is zero. If all other influencing factors remain constant, this happens increasingly quickly as the expiry date approaches. On the expiry date itself, the value of the option is determined solely by its intrinsic value. This is an important consideration for you as the holder of the option. Generally, you realize any profit not by exercising the option but by selling it. By selling the option, you can realize not only the intrinsic value but also the time value, which would be lost if the option were to be exercised.

Premium
With a call option, the premium states how much more expensive it would be to purchase the underlying asset by purchasing and immediately exercising the option right at the time in question, rather than purchasing the underlying asset directly. In the case of a put option, the premium states how much more expensive it would be to sell the underlying asset by purchasing and immediately exercising the option right at the time in question, rather than selling the underlying asset directly. As a rule, in order to allow the option to be valued more accurately, the premium is expressed on per-year basis, i.e. in relation to the years of its term (annual premium). If the option is “in the money”, the premium expresses the time value of the option as a percentage of the currency market price of the underlying asset.

Break-even point
The break-even point of an option can be defined in terms of a particular market price of the underlying asset. The underlying asset must reach this market price in order for the option to be able to be exercised without a loss. This market price does not correspond to the strike price, but rather always lies a certain amount above it (in the case of call option) or below it (in the case of put option). The benefit obtained from the exercise of the option must balance out the price paid for the option plus the transaction costs. The break-even point is only of significance in determining your profit threshold if you intend to exercise your option right. If, on the other hand, you wish to sell your option, the break-even points tells you nothing about your actual profit or loss. You will make a profit if the proceeds from the sale exceed the purchase price of the option plus all transaction costs.