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The price of an option, or its “premium”, is composed of two
elements: The option’s “intrinsic value” and its “time value”.
For a call option, the intrinsic value of the option is the amount,
if any, by which the price of the underlying security exceeds the
option’s strike price. The balance of the premium is the time
value of the option. For a put option, the intrinsic value of the
option is the amount, if any, by which the strike price exceeds the
price of the security.
Generally, an option’s price in the marketplace will be
greater than its intrinsic value. The additional amount of premium
beyond the intrinsic value reflects that traders are willing to pay
the “time value” of money or the option’s “time premium”. Market
participants are willing to pay this additional amount because of
the protective characteristics afforded by an option over an
outright long or short position in the underlying security.
An option is “in the money” when the option’s strike price is
less than the current market price of the underlying instrument;
i.e., when it would be economically favorable for the option holder
to exercise the option. An option is “out of the money” when it
would be economically unfavorable to exercise the option. When the
option strike price equals the market price of the underlying
security, an option is “at the money”.
In the futures market, a “spread” consists of the simultaneous
establishment of two opposite positions for delivery of the same
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Last modified: May 25, 2011