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Options Crash Course

Options Crash Course: Ep #2 - Deconstructing Option Prices

Options Crash Course

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

Yesterday, we kicked off the Options Crash Course, by building the foundation that serves as the source to all option strategies - the option contract. Well in that piece, we learned that the only floating variable that is pertinent to the option contract is its price, and today, we want to dive deeper into that price to uncover its inner workings.

To do that, we start with the governor to all things option pricing: the Black-Scholes Option Pricing Model. In working through a basic overview of this model, we learn that option pricing is dependent on six different factors, all of which work together to build the probabilistic function that is the BSM. Then, we break option prices down into their two component parts: intrinsic value and extrinsic value. While intrinsic value measures the inherent worth of the option, extrinsic value represents the added “premium” that is tacked on to establish the option’s price.

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