Terminology Recap

Each option has a specific strike price and when someone buys an option, he/she is paying a premium for that option. The premium paid is for “the chance that the underlying will reach (or possibly exceed) the strike price” and for the risk that something can happen.

Have a look at the price graph we have shown and discussed before.

When you wanted price insurance for a strike price of 77 (position 4) and the price of the underlying market was actually trading at around 75.2, then 77 was relatively far above that price. The premium that the insurance broker charged you for the option was for “the chance that the price could reach and then go above a price of 77” in the allowed time.

The actual option, right at that point in time, was worthless and held no value and if that option expired at the point in time when price was trading at 75.2, then you would not have been able to do anything with it. It would also not have been possible to buy the underlying market at the price of 77 either, but you could have bought it at 75.2.

So right at the moment that you bought the option, it was worth nothing. The premium that you paid was only for “the chance that the price COULD move up and go above 77” – in other words, you were paying for the risk that the broker was taking in giving you insurance.

Now compare the above to a Call option at a strike price of say 73 (position 1). If you opted for the strike price of 73, then that option would have already had a lot of value in it and if you decided to exercise it before expiry (at a price of 75.2), it would mean that you would have bought the underlying market at the strike price of 73!

Let’s look at that again. If you bought at 73 and immediately sold when the price was trading at 75.2, then you would have realized an immediate profit of (75.2 – 73) = 2.2 points of profit.

Depending on the value of the underlying market e.g. Crude Oil, then one point is valued at $1,000 and 2.2 points = $2,200 profit! BUT, it ALSO had the same amount of time to move higher in price than your 77 strike option had. So, if you wanted the insurance broker to sell you THIS insurance premium instead, then he would have to consider that there was already some value in the option PLUS there was also value associated with the time left until the option expires!