Current option prices. An Example of How Options Work

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Please read Characteristics and Risks of Standardized Options before deciding to invest in options. Option Value Where an option gets its price can seem like smoke and mirrors when first learning about option trading, but it is actually pretty simple. These values change based on three inputs: strike price current option prices relation to the stock price, implied volatility, and time until expiration.

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Intrinsic Value - Call Option This is the most straightforward value to understand. An option has intrinsic value if it will be worth something at expiration.

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To calculate how much intrinsic value an option has, all we have to do is measure the difference between my ITM strike and the stock price. If an option is out of the money OTMit has no intrinsic value. That is why the option has no worth at expiration, and is considered to be OTM.

Call options have intrinsic value if they are below the stock price. Call options that are above the stock price have no intrinsic value, as they would be worthless at expiration.

Interest rate Dividends and risk-free interest rate have a lesser effect. Changes in the underlying security price can increase or decrease the value of an option. These price changes have opposite effects on calls and puts. For instance, as the value of the underlying security rises, a call will generally increase. However, the value of a put will generally decrease in price.

Intrinsic Value - Put Option Intrinsic value works the same way with put options, but on the opposite side of the coin. Since a put option is the right to sell shares at a certain strike, these options have intrinsic value if they are above the stock price.

Specifically, option premiums are based on the Nobel Prize-winning Black-Scholes model, which considers multiple variables to arrive at a fair price. Specifically, the calculation weighs: The price of the underlying stock, assuming constant drift and volatility The strike price of the option The amount of time until the option expires A constant, risk-free interest rate The Black-Scholes option pricing model does not account for dividends.

The intrinsic value calculation is the same - it is just the difference between our ITM strike and the stock price. Just like calls, if a put option is OTM it has current option prices intrinsic value. This renders our put useless at expiration.

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Put options have intrinsic value if they are above the stock price. Put options that are below the stock price have no intrinsic value, as they would be worthless at expiration. So why do OTM call and put options still have value if they will be worthless at expiration?

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Because there is still time and implied volatility of the underlying. This is known as extrinsic value. Extrinsic Value Extrinsic value is a little more complicated, because it has multiple factors that affect it.

Article Reviewed on July 30, Michael J Boyle Updated July 30, As you learn about trading optionsyou'll find that options traders use terms that are unique to options markets. You'll see these terms appear often and understanding them can have a significant effect on your chances for profitability on an options trade. Defining Options Before getting into options terminology, it's helpful to get some background on options themselves.

But the main factors are time and implied volatility. At the money ATM options are closest to the stock price, and have the most current option prices value.

Major Factors Influencing Options Premium

Extrinsic value is very similar to a standard bell curve if there is no volatility skew. The time factor of extrinsic value is the easiest to understand.

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  • The strike price may be set by reference to the spot price market price of the underlying security or commodity on the day an option is taken out, or it may be fixed at a discount or at a premium.
  • The Bottom Line Options are contracts that give option buyers the right to buy or sell a security at a predetermined price on or before a specified day.
  • As a result, time value is often referred to as an option's extrinsic value since time value is the amount by which the price of an option exceeds the intrinsic value.
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It is very similar to an insurance contract. Regardless of what someone is insuring, they will have a higher total premium if they insure it over the course of a year compared to 30 days. If we picture ourselves as the insurance agency offering you the option as protection and you sell an OTM option that has 60 days until expiration, it will be worth much more than that same option that has 7 days to expiration.

There is more time associated with the contract, which translates directly into a larger extrinsic value.

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As we get closer to expiration, the extrinsic value will dissipate. On expiration day, options trade very close to their intrinsic value as there is not much time left until expiration and not a lot of time for the underlying to move in price.

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This leads us to our next contributing factor, which is implied volatility IV. Implied volatility is simply speculation of where an underlying could go over the course of a year.

It is derived from the current option market of an underlying.

Options Pricing

If a person is a skydiver, their premium would be through the roof. They would have a lot more perceived risk associated with their lifestyle, and a lot more uncertainty of what might happen to them.

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They would have a very high implied volatility, and therefore a higher insurance premium. If a person was a homebody that did not partake in risky hobbies, their premium would be much lower. The risk of something happening to them is low, as there is not much perceived risk associated with their lifestyle. They would have a very low implied volatility, and therefore a lower insurance premium.

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Understanding those factors and the placement of the strike compared to the stock price will give you a better understanding of why an option has a certain price.