# Option Pricing Basics

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. The price of an option, called the premium, is composed of a number of variables. Options traders need to be aware of these variables so they can make an informed decision about when to trade an option.

When investors buy options, the biggest driver of outcomes is the price movement of the underlying security or stock. Call option buyers of stock options need the underlying stock price to rise, whereas put option buyers need the stock's price to fall.

However, there are many other factors that impact the profitability of an options contract. Some of those factors include the stock option price or premium, how much time is remaining until the contract expires, and how much the underlying security or stock fluctuates in value.

Options prices, known as premiums, are composed of the sum of its intrinsic and time value.

Intrinsic value is the price difference between the current stock price and the strike price.

An option's time value or extrinsic value of an option is the amount of premium above its intrinsic value.

Time value is high when more time is remaining until expiry since investors have a higher probability that the contract will be profitable.

## Understanding the Basics of Option Prices

Options contracts provide the buyer or investor with the right, but not the obligation, to buy and sell an underlying security at a preset price, called the strike price. Options contracts have an expiration date called an expiry and trade on options exchanges. Options contracts are derivatives because they derive their value from the price of the underlying security or stock.

A buyer of an equity call option would want the underlying stock price to be higher than the strike price of the option by expiry. On the other hand, a buyer of a put option would want the underlying stock price to be below the put option strike price by the contract's expiry.

There are many factors that can impact the value of an option's premium and ultimately, the profitability of an options contract. Below are two of the key components that comprise of an option's premium and ultimately whether it's profitable, called in the money (ITM), or unprofitable, called out of the money (OTM).

## Intrinsic Value

One of the key drivers for an option's premium is the intrinsic value. Intrinsic value is how much of the premium is made up of the price difference between the current stock price and the strike price.

For example, let's say an investor owns a call option on a stock that is currently trading at $49 per share. The strike price of the option is $45, and the option premium is $5. Because the stock price is currently $4 more than the option's strike price, then $4 of the $5 premium is comprised of intrinsic value.

In the example, the investor pays the $5 premium upfront and owns a call option, with which it can be exercised to buy the stock at the $45 strike price. The option isn't going to be exercised until it's profitable or in-the-money. We can figure out how much we need the stock to move in order to profit by adding the price of the premium to the strike price: $5 + $45 = $50. The break-even point is $50, which means the stock must move above $50 before the investor can profit (excluding broker commissions).

In other words, to calculate how much of an option's premium is due to intrinsic value, an investor would subtract the strike price from the current stock price. Intrinsic value is important because if the option premium is primarily made up intrinsic value, the option's value and profitability are more dependent on movements in the underlying stock price. The rate at which a stock price fluctuates is called volatility.

## Measuring Intrinsic Value

An option's sensitivity to the underlying stock's movement is called delta. A delta of 1.0 tells investors that the option will likely move dollar for dollar with the stock, whereas a delta of 0.6 means the option will move approximately 60 cents for every dollar the stock moves.

The delta for puts is represented as a negative number, which demonstrates the inverse relationship of the put compared to the stock movement. A put with a delta of -0.4 should increase by 40 cents in value if the stock drops $1 per share.

## Time Value

The time remaining until an option's expiration has a monetary value associated with it, which is known as time value. The more time that remains before the option's expiry, the more time value is embedded in the option's premium.

In other words, time value is the portion of the premium above the intrinsic value that an option buyer pays for the privilege of owning the contract for a certain period. As a result, time value is often referred to as extrinsic value.

Investors are willing to pay a premium for an option if it has time remaining until expiration because there's more time to earn a profit. The longer the time remaining, the higher the premium since investors are willing to pay for that extra time for the contract to become profitable or have intrinsic value.

Remember, the underlying stock price needs to move beyond the option's strike price in order to have intrinsic value. The more time that remains on the contract, the higher the probability the stock's price could move beyond the strike price and into profitability. As a result, time value plays a significant role, in not only determining an option's premium but also the likelihood of the contract expiring in-the-money.

## Time Decay

Over time, the time value decreases as the option expiration date approaches. The less time that remains on an option, the less incentive an investor has to pay the premium since there's less time to earn a profit. As the option's expiration date draws near, the probability of earning a profit becomes less likely, resulting in an increasing decline in time value. This process of declining time value is called time decay.

Typically, an options contract loses approximately one-third of its time value during the first half of its life. Time value decreases at an accelerating pace and eventually reaches zero as the option's expiration date draws near.

Time value and time decay both play important roles for investors in determining the likelihood of profitability on an option. If the strike price is far away from the current stock price, there needs to be enough time remaining on the option to earn a profit. Understanding time decay and the pace at which time value erodes is key in determining whether an option has any chance of having intrinsic value.

Options with more extrinsic value are less sensitive to the stock's price movement while options with a lot of intrinsic value are more in sync with the stock price.

## Measuring Time Value

Time value is measured by the Greek letter theta. Option buyers need to have particularly efficient market timing because theta eats away at the premium. A common mistake option investors make is allowing a profitable trade to sit long enough that theta reduces the profits substantially.

For example, a trader may buy an option for $1, and see it increase to $5. Of the $5 premium, only $4 is intrinsic value. If the stock price doesn't move any further, the premium of the option will slowly degrade to $4 at expiry. A clear exit strategy should be set before buying an option.

## Time Value and Volatility

The rate at which a stock's price fluctuates, called volatility, also plays a role in the probability of an option expiring in the money. Implied volatility, also known as vega, can inflate the option premium if traders expect volatility.

Implied volatility is a measure of the market's view of the probability of stock's price changing in value. High volatility increases the chance of a stock moving past the strike price, so options traders will demand a higher price for the options they are selling.

This is why well-known events like earnings are often less profitable for option buyers than originally anticipated. While a big move in the stock may occur, option prices are usually quite high before such events, which offsets the potential gains.

Conversely, when a stock price is very calm, option prices tend to fall, making them relatively cheap to buy. However, unless volatility expands again, the option will stay cheap, leaving little room for profit.

## Conclusion

An option's value or premium is determined by intrinsic and extrinsic value. Intrinsic value is the moneyness of the option, while extrinsic value has more components. Before booking an options trade, consider the variables in play and have an entry and exit strategy.

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