The Basics of Option Pricing – How to Understand It

The price a buyer pays for an option contract is called the option premium.

This article will explain the three things that make up the pricing of an option: intrinsic value, time value and implied volatility. It is important to understand what these three things are in order to differentiate between a good and a bad trade when dealing with options.

Keep in mind, the buyer of an option, who is known as the option holder, pays a premium for the option contract to the seller, who is known as the option writer. Most option contracts represent 100 shares of the underlying stock. Therefore, premiums are quoted on a per-share basis. A $1 premium for an option contract will cost $100 in total.

Now, let’s get into the three things that make up the price of an option contract.

Intrinsic value is the difference between the market price and the strike price of the underlying security.

For example, The Home Depot, Inc. (NYSE: HD) has a market price of $195. If an investor owns a call option for HD with a strike price of $190, then it has an intrinsic value of $5. This is known to be “in-the-money.” With this option, the option buyer can profit $5 per share. This is because the option buyer could buy the shares at $190, then immediately sell the shares at $195.

If an investor owns a call option for HD with a strike price of $190, but the market price of HD is $188, then there is no intrinsic value. This is known as being “out-of-the-money.” If this option expires and it is “out-of-the-money,” then it has no value.

Let’s look at a put option example. Assume HD has a market price of $195. If an investor owns a put option for HD with a strike price of $200, then it has an intrinsic value of $5. This is known to be “in-the-money.” This would give the option owner a profit of $5 per share because he could buy the shares at $195, then immediately sell the shares at $200.

If an investor owns a put option for HD with a strike price of $190, but the market price of HD is $193, then there is no intrinsic value. Just like the call option, this is known as being “out-of-the-money.” If this option expires and it is “out-of-the-money,” then it has no value.

The farther “in-the-money” an option is, the higher the intrinsic value of the option will be. The higher the intrinsic value, the higher the price for the option will be.

If it is “out-of-the-money” by the expiration date, then it will expire and have no value. However, if it is “out-of-the-money” before the expiration date, then it still has value because of time value and implied volatility.

The time value of an option contract is dependent upon the length of time remaining before the option contract expires.

The more time an option has until expiration, the greater the time value. As the option approaches its expiration date, the time value decreases. When the option expires, it becomes worthless.

For example, an option contract for HD, expires in 30 days and is “out-of-the-money.” This has a greater time value than the HD option that expires in seven days, with everything else being equal. This difference in valuation is due to having more time, and therefore a higher chance, for the 30-day option to move from “out-of-the-money” to “in-the-money.”

The greater the time value is on an option, then the higher the overall value of the option will be.

Implied volatility indicates how volatile the underlying stock’s price may be in the future.

High implied volatility means that the stock is expected to have large price swings in either direction. Low implied volatility means that the stock is expected not to swing in either direction significantly.

Higher implied volatility indicates a higher price for the option. Conversely, a lower implied volatility indicates a lower price.

For example, if the HD option has an implied volatility of 5% and the implied volatility increases to 15%, then the price of the HD option also would increase.

The intrinsic value, time value and implied volatility of an option contract determine the pricing of that contract. An increase in these things leads to an increase in the option’s price. Understanding these three factors and how they make up the pricing of options will better prepare an investor to make intelligent investment decisions when it comes to purchasing or selling option contracts.