Understanding the Basics of Option Pricing

By: Wayne Duggan

One of the first things many new option traders learn about the options market is how different option pricing is from stock pricing. Because option contracts have a time element involved, the value in each option contract is a bit more complicated than a simple stock price.

Intrinsic Value
The intrinsic value of an option contract is the value the contract would hold if it expired immediately. If the contract’s intrinsic value is greater than $0, the contract is considered to be “in-the-money.” If the contract’s intrinsic value is $0, it is considered “out-of-the-money.”

For example, consider a call option contract with a strike price of $100 and an expiration date of January 14, 2022. If the underlying stock is currently trading at $95, the intrinsic value of the call contract is $0. If the contract were to expire immediately, the stock price would be below the strike price of the contract, and it would expire worthless. This call contract would currently be considered out-of-the-money.

If that same contract were a put contract instead, the intrinsic value would currently be $5 ($100 minus the current $95 stock price). Because the stock price is currently below the $100 strike price, the put contract is in-the-money.

A call contract’s intrinsic value is always the stock’s current price minus the strike price. A put contract’s intrinsic value is always the strike price minus the current stock price. Intrinsic value can never be negative, so any out-of-the-money contract automatically has a $0 intrinsic value.

Time Value
The time value of an option contract is based on several factors, including the length of time until the contract expires. Other factors that contribute to the time value of an option contract include the volatility of the underlying stock, the current risk-free interest rate, the dividend yield of the underlying stock and how close the underlying stock price is to the strike price of the contract.

From a practical standpoint, the time value of an option contract is a premium the buyer pays to play the waiting game and hope a contract trades deeper into the money. Time value decays as the contract approaches its expiration date and then eventually hits zero when the contract expires. An option contract buyer is hoping that the contract will gain enough intrinsic value to offset the decay in time value.

For example, the hypothetical call option contract with a strike price of $100 and an expiration date of January 14, 2022 mentioned above might cost $4 per contract today if the underlying stock is currently trading at $95. Given the contract is currently out-of-the-money, it has $0 of intrinsic value. Therefore, the entire $4 contract price would be time value. The buyer is paying $4 today in hopes the underlying stock price will rise above $100 per share between now and January 14, 2022.

Advanced Pricing Calculations
Even casual option traders should have a basic understanding of the intrinsic value and time value of option contracts before making any option trades. However, traders who want to learn more about the advanced quantitative mathematics behind option pricing should research the Black-Scholes options pricing model, the Nobel Prize-winning mathematical model professional option traders use to price option contracts.

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