how can individual investors determine if an option premium is worth paying in DITM calls/puts?
Best Answer
348 points
Sensei answered one year ago …
It sounds like you're asking if there is a formula of some sort that you can use to determine the "worth" of the option premium. Simply stated, it doesn't exist. The price of an option is made up of two parts - the intrinsic value (the difference between the market price and the strike price) and the extrinsic value (the additional amount you're paying for the time until expiration.) Accepting that the intrinsic value is "worth it", the question then becomes, "How can I tell if the extrinsic value is worth paying?"
A number of factors go into determining the extrinsic value including, but not limited to, the length of time to expiration, the volatility of the underlying security and the perceived outlook for the stock price. Like all investment decisions, the importance of these issues is often a personal matter. Would you pay a bigger premium (i.e. more extrinsic cost) for Apple or for Research In Motion? A proponent of one of these will feel one way; a supporter of the other will fell differently. So there really isn't a simple answer to your question. It depends.
One thing you can do to help in your decision is to consider the following question ... "By the time I have to exercise the option (or sell it as the case may be), will the underlying stock have risen enough to compensate me for the additional cost?"
For example, say the stock is $ 35, the strike price is $ 30, and the option will cost you $ 6.50. To profit on this trade, the stock has to be higher than $ 36.50 by the exercise day. That's an increase of $ 1.50 from the current price ... about 4.3%. What are the chances of that? Good? Then you know what to do. Unlikely? Again, you know what to do - or rather what not to do.
Back to your question ... "Is the premium worth it?" That depends on how you feel about the stock getting to $ 36.50. And that is a personal view - something that makes you an "individual investor" in more ways than one.
