Find out how prop trading differs from retail trading and how certain trading mechanics are the same!
Where an option gets its price can seem like smoke and mirrors when first learning about option trading, but it is actually pretty simple. Option value, also known as option premium, is really just made up of two contributing factors - intrinsic & extrinsic value. These values change based on three inputs: strike price in relation to the stock price, implied volatility, and time until expiration. That’s it! We won’t leave you there though - let’s dive a little deeper and start with intrinsic value.
This is the most straightforward value to understand. An option has intrinsic value if it will be worth something at expiration. Enter the call option:
If the stock price is at $50, and we own a call option at 45, that call option has intrinsic value, which means it is in the money (ITM). At expiration, we will have the right to buy 100 shares of stock for $45, even when the stock price is at $50. To calculate how much intrinsic value an option has, all we have to do is measure the difference between my ITM strike and the stock price. This call option has $5.00 of intrinsic value per share. (50 - 45 = 5).
If an option is out of the money (OTM), it has no intrinsic value. In the same example, if we owned the 45 call and the stock price was at $40, it would have no intrinsic value. Why would we buy shares at $45 when wecan buy shares in the market at $40? we wouldn’t! That is why the option has no worth at expiration, and is considered to be OTM.
Call options have intrinsic value if they are below the stock price. Call options that are above the stock price have no intrinsic value, as they would be worthless at expiration.
Intrinsic value works the same way with put options, but on the opposite side of the coin. Since a put option is the right to sell 100 shares at a certain strike, these options have intrinsic value if they are above the stock price.
If the stock price is at $50, and we own a put option with a strike at 56, the put option has intrinsic value. We have the right to sell 100 shares at $56, even when the stock price is at $50. The intrinsic value calculation is the same - it is just the difference between our ITM strike and the stock price. This put option would have $6.00 of intrinsic value per share (56 - 50 = 6).
Just like calls, if a put option is OTM it has no intrinsic value. If we owned that 56 put and the stock price was at $60, the put would have no intrinsic value. We would have the right to sell shares at $56, but we could sell the shares at $60 in the market. This renders our put useless at expiration.
Put options have intrinsic value if they are above the stock price. Put options that are below the stock price have no intrinsic value, as they would be worthless at expiration.
So why do OTM call and put options still have value if they will be worthless at expiration? Because there is still time and implied volatility of the underlying. This is known as extrinsic value.
Extrinsic value is a little more complicated, because it has multiple factors that affect it. But the main factors are time and implied volatility. Both ITM and OTM options have extrinsic value, but OTM options are purely made up of extrinsic value. At the money (ATM) options are closest to the stock price, and have the most extrinsic value. Extrinsic value is very similar to a standard bell curve if there is no volatility skew. Extrinsic value is highest in ATM options, and trails off as you go further OTM and further ITM.
The time factor of extrinsic value is the easiest to understand. It is very similar to an insurance contract. Regardless of what someone is insuring, they will have a higher total premium if they insure it over the course of a year compared to 30 days. It’s the same with options. If we picture ourselves as the insurance agency offering you the option as protection and you sell an OTM option that has 60 days until expiration, it will be worth much more than that same option that has 7 days to expiration. There is more time associated with the contract, which translates directly into a larger extrinsic value. As we get closer to expiration, the extrinsic value will dissipate. The daily decay of an option’s price is known as theta decay. On expiration day, options trade very close to their intrinsic value as there is not much time left until expiration and not a lot of time for the underlying to move in price. This leads us to our next contributing factor, which is implied volatility (IV).
Implied volatility is simply speculation of where an underlying could go over the course of a year. It is derived from the current option market of an underlying. Envision that same insurance contract, but this time we’re talking about life insurance. If a person is a skydiver, their premium would be through the roof. They would have a lot more perceived risk associated with their lifestyle, and a lot more uncertainty of what might happen to them. They would have a very high implied volatility, and therefore a higher insurance premium.
If a person was a homebody that did not partake in risky hobbies, their premium would be much lower. The risk of something happening to them is low, as there is not much perceived risk associated with their lifestyle. They would have a very low implied volatility, and therefore a lower insurance premium.
As you can see, time & IV changes can impact extrinsic value pretty drastically. Option value is simply intrinsic + extrinsic value, and those values change based on a number of factors. Understanding those factors and the placement of the strike compared to the stock price will give you a better understanding of why an option has a certain price.
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Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
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