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Deconstructing Option Prices

From Theory To Practice

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.

Option prices materialize from the option pricing models, such as the Black-Scholes, that we have all become at least somewhat familiar with. From these calculations, option prices can be boiled down to two pieces: the intrinsic value and the extrinsic value, or time value. The intrinsic value represents the current worth of the option, and the extrinsic value encapsulates all of the option’s risk. Intrinsic values can never be negative because the long option holder can simply walk away from the option if the underlying price moves against him, and time values must always be greater than zero (at least in theory) because there is always some amount of time left prior to expiration. Our core philosophy at tastytrade is selling OTM options, so our primary focus is on managing and monitoring time values because OTM options by definition have no intrinsic values.

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