How Are Stock Options Priced? by www.OptionTradingpedia.com

How Are The Prices of Stock Options Determined?

Stock Option Pricing - 2 Main Components, Intrinsic Value & Extrinsic Value

The price of an option contract, or sometimes known as the option premium, consists of 2 main components : Intrinsic Value and Extrinsic Value, governed by the principle of Put Call Parity.

Stock Option Pricing - What Is Intrinsic Value?

Intrinsic value is simply the value that is already built into the option at the moment that you bought it.

Example: If a stock is currently trading at $50, a Call option with a Strike Price of $40 will have a $10 value already built into it as it allows you to buy a $50 stock at $40. Therefore, that option will be priced at $10 + Extrinsic Value. Similarly, if that same stock is currently trading at $50, a Put option with a Strike Price of $60 will have $10 value already built into it as it allows you to immediately sell that same stock at $60 the moment you bought it. That option will also be priced at $10 + Extrinsic Value. Such an Option Contract with intrinsic value built into it is known as an In The Money Option (ITM Option).

How To Calculate Intrinsic Value?

The intrinsic value of a call option is obtained simply by deducting the prevailing market price of the underlying stock by the strike price of the call option.

Intrinsic Value For Call Option = Stock Price - Call Strike Price

Example : Assume GOOG is trading at $350 and it's March$300Call Option is asking for $52.00. It's intrinsic value would be : $350 - $300 = $50.

The intrinsic value of a put option is obtained simply by deducting the strike price of the put option by the prevailing market price of the underlying stock.

Intrinsic Value For Put Option = Put Strike Price - Stock Price

Example : Assume GOOG is trading at $350 and its March$400Put option is asking for $51.80. It's intrinsic value would be : $400 - $350 = $50.

A negative value indicates that there is no intrinsic value. An option which contains intrinsic value is known as an In The Money (ITM) Option.

Read the full tutorial on Intrinsic Value.

Stock Option Pricing - What Is Extrinsic Value?

Extrinsic Value, or sometimes known as the Premium Value or Time Value, of an option is the part of the price that is determined by factors other than the price of the underlying stock. This is what you are paying the seller of the option for the risk that the seller is undertaking for selling you the option contract. This "risk money" you are paying the seller is justified and determined by 4 main factors : Time to expiration, Interest Rates, Volatility and Dividends payable. One would need a pricing model such as the Black-Scholes Model to accurately calculate the Extrinsic Value of a stock option.

The price of a stock option consists only of it's Extrinsic Value when there is no built in value at the moment you bought it (hence no intrinsic value).

Layman loves to call the price of any option contract it's "Option Premium" but that is actually a misleading term. As you already know, the price of an option consists of its intrinsic value and premium, not just its premium alone, unless it is an Out Of The Money option where there is no intrinsic value. Professionals simply refer to the cost of an option contract at its "Asking Price" when trading or its "Theoretical Value" when calculating using a pricing model.

Example: If a stock is currently trading at $50, a Call option with a Strike Price of $60 will have no intrinsic value built into it. Similarly, a Put option on that same stock with a strike price of $40 will have no intrinsic alue built into it. Such an option contract with no intrinsic value built into it is known as an Out of The Money(OTM) Option.

Read the full tutorial on Extrinsic Value.

How To Calculate Extrinsic Value?

The extrinsic value of a call option is obtained simply by deducting the price of the call option by it's intrinsic value.

Extrinsic Value Of Call Option = Call Option Price - Intrinsic Value

Following up from the previous example : Assume GOOG is trading at $350 and it's March$300Call Option is asking for $52.00. It's intrinsic value is $50. It's Extrinsic Value would be $52 - $50 = $2.

The Extrinsic Value of a put option is obtained simply by deducting the price of the put option by its intrinsic value.

Extrinsic Value Of Put Option = Put Option Price - Intrinsic Value

Following up from the previous example: Assume GOOG is trading at $350 and its March$400Put option is asking for $51.80. It's intrinsic value is $50. It's Extrinsic Value would be $51.80 - $50 = $1.80.

Intrinsic Value & Extrinsic Value's behavior

The intrinsic value of an option contract remains the same as long as the price of the underlying asset do not change, however, the Extrinsic Value of that same contract reduces as time goes by even if the underlying asset remains completely stagnant. This is known as the " Time Decay". The rate at which this time decay happens varies according to the amount of time left to expiration. The closer to expiration, the more pronounced this decay effect becomes due to a higher theta value.

Eventually, when a stock option contract expires, there will be no more Extrinsic Value left. Therefore, if you bought an Out-Of-The-Money (OTM) call option and the price of the underlying stock fails to rise above the strike price, your call option contract which consists only of the Extrinsic Value, decays to zero and you stand to lose all your money.

Stock Option Pricing - How Is Extrinsic Value Priced?

Option premium is commonly priced in the exchanges using the Black-Scholes model. It combines the time remaining until expiration, the strike price, the prevailing interest rate, the current price of the underlying and an estimate of future volatility known as the implied volatility (IV) to generate a theoretical price for an option.

Because implied volatility is the only unknown input, proper options pricing is entirely dependent on accurate forecasts of future volatility. The usual approach is to measure the actual volatility of the underlying over the recent past, adjust for anticipated news events such as an upcoming earnings release, and add some margin for safety. This approach works fairly well for liquid (heavily traded) options.

Stock Option Pricing - Other Considerations

Options pricing for strike prices a long way from the current price of the underlying is a little trickier. Partly as a reflection of their lower liquidity, and partly as acknowledgment that unexpected large price movements can and do happen, such options have an additional level of margin added to their price.

Options pricing must also account for a few other variables. If the underlying happens to pay dividends, and one is payable prior to expiration, the pricing model must take that into account. Options pricing is also sensitive to interest rates; if the overall economic situation is one where interest rates are likely to move significantly in the near future, adjustments will be necessary.

Stock Option Pricing Questions

:: Difference In Price Between Different Maturities? :: Will Put Options Have Intrinsic Value Without Stock Dropping?

Beginners need not go too deeply into how exactly the Extrinsic Value of an option contract is derived at this point. The most important concept to understand after reading this page is the concept of what constitutes an In The Money (ITM) option and what constitutes an Out Of The Money (OTM) option.

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Stock Options Pricing