Options Pricing

Main Components of an Options Premium

The premium of an option has two main components: intrinsic value and time value.

Intrinsic Value (Calls):

When the underlying security's price is higher than the strike price a call option is said to be "in-the-money."

Intrinsic Value (Puts):

If the underlying security's price is less than the strike price, a put option is "in-the-money." Only in-the-money options have intrinsic value, representing the difference between the current price of the underlying security and the option's exercise price, or strike price.

Time Value:

Prior to expiration, any premium in excess of intrinsic value is called time value. Time value is also known as the amount an investor is willing to pay for an option above its intrinsic value, in the hope that at some time prior to expiration its value will increase because of a favorable change in the price of the underlying security. The longer the amount of time for market conditions to work to an investor's benefit, the greater the time value.

Six Major Factors Influencing Options Premium

There are six major factors that influence option premiums. The factors having the greatest effect are:

• A change in price of the underlying security
• Strike price
• Time until expiration
• Volatility of the underlying security
• Dividends/Risk-free 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 and the value of a put will generally decrease in price. A decrease in the underlying security's value will generally have the opposite effect.

The strike price determines whether or not an option has any intrinsic value. An option's premium (intrinsic value plus time value) generally increases as the option becomes further in the money, and decreases as the option becomes more deeply out of the money.

Time until expiration, as discussed above, affects the time value component of an option's premium. Generally, as expiration approaches, the levels of an option's time value, for both puts and calls, decreases or "erodes." This effect is most noticeable with at-the-money options.

The effect of trading volatility is the most subjective and perhaps the most difficult factor to quantify, but it can have a significant impact on the time value portion of an option's premium. Volatility is simply a measure of risk (uncertainty), or variability of price of an option's underlying security. Higher volatility estimates reflect greater expected fluctuations (in either direction) in underlying price levels. This expectation generally results in higher option premiums for puts and calls alike, and is most noticeable with at-the-money options.

The effect of an underlying security's dividends and the current risk-free interest rate have a small but measurable effect on option premiums. This effect reflects the "cost of carry" of shares in an underlying security -- the interest that might be paid for margin or received from alternative investments (such as a Treasury bill), and the dividends that would be received by owning shares outright.

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