How Are Options Priced?

The price of an option, known as the "premium," is determined in the open market. It is defined as the price of an options contract that the holder (purchaser) of the option pays to the writer (seller) of the option for the rights conveyed by the terms of the options contract. This premium is the only risk that the holder of a long call or long put can incur (along with commissions costs), and conversely, the only reward the writer of an option can potentially gain.

An option premium is comprised of two overall values: time value and intrinsic value.

Intrinsic Value

The intrinsic value of an option is defined as the amount by which the strike price of the options contract is in-the-money. For a call option, this would be its intrinsic value, the amount by which the underlying asset price is above the strike price of the options contract. For a put option, the intrinsic value would equal the amount by which the underlying asset is below the strike price of the options contract. If the options contract strike price and underlying asset price are exactly the same, then the intrinsic value of the options contract is zero.

Example of intrinsic value for a call option:

  • Underlying asset: XYZ trading at 100
  • XYZ Call option with a strike price of 90
  • Intrinsic value = 10 (XYZ is 10 points above the strike price of 90)

Example of intrinsic value for a put option:

  • Underlying asset: XYZ trading at 100
  • XYZ Put option with a strike price of 110
  • Intrinsic value = 10 (XYZ is 10 points below the strike price of 110)

Time Value

The time value of a premium is defined as the amount by which the option premium itself exceeds its intrinsic value. This value is attributable to the amount of time remaining until the expiration of the options contract, volatility, and other factors.

Example of how to determine the time value premium:

XYZ is trading at 50, and you buy 1 XYZ July 45 call at 7. Your options contract is in-the-money by 5 points (the amount that the price of XYZ, $50, is above the strike price of $45). This 5 point amount is the intrinsic value. To determine the time value, subtract the intrinsic value from the premium (Premium - Intrinsic Value = Time Value). Using the example above, 7.00 (premium) - 5.00 (Intrinsic Value) = 2.00 (Time Value).

An option generally has the largest amount of time value when the underlying asset price is the same as the strike price of the option. This is because there is no intrinsic value. As an options contract begins to fall deeper in or out-of-the-money, its time value decreases substantially. If it is an in-the-money option, the intrinsic value will increase and the time value will decrease. If it is an out-of-the-money option, the option has only time value that will decrease, as it becomes deeper out-of-the-money, and closer to expiration.

For more information, see Determining the Intrinsic Value and Time Value of an Option.