Lesson 2: Where does an option’s price come from?

Let’s explore the things that affect an option’s price. Remember, the price you pay for an option is called the premium. In this lesson, we’ll first consider the two main components of an option’s premium: intrinsic value and time value. 

An option’s intrinsic value is the difference between the linked asset’s current price and the strike price of the option. This is a pretty straightforward part of the option’s price. 

Imagine that the current price of XYZ is $13, and you have a call option that expires in two months that lets you buy XYZ for $12. Your call option gives you an immediate $1 per share discount on XYZ, so the intrinsic value of your option is $1. Another way to say this is your option is $1 “in-the-money.” 

• In-the-money options are those where the strike price is favourable to the holder of the option. For call options, this means the strike price is below the current market price of the underlying asset. For put options, it means the strike price is above the market price of the underlying asset. In-the-money options have both intrinsic value and time value.
• At-the-money options are those where the strike price is equal to the current market price of the underlying asset. At-the-money options have no intrinsic value, only time value. 
• Out-of-the-money options are those where the strike price is not favourable to the holder of the option. For call options, this means the strike price is above the current market price of the underlying asset. For put options, it means the strike price is below the current market price of the underlying asset. Out-of-the-money options have no intrinsic value, only time value.

Let's use the previous example of XYZ with:

• a current price of $13,
• a strike price of $12,
• an expiry date happening in two months

If you decide to sell the call option to someone else before it expires, instead of using it yourself, would you sell it for $1? Probably not, because there are still two months until it expires. Over the next two months, XYZ could really jump in price, making the option much more valuable than it is now. This is not guaranteed, of course, XYZ could also decline or not move at all. But the possibility exists.

Your option is currently worth $1 (intrinsic value) plus something extra because of the time left until it expires. That “something extra” will be reflected in the price and is called time value.

Now let’s think about a different scenario. The current price of XYZ is still $13, but you choose a different call option that lets you buy XYZ for $14 and this call option also expires in two months. This option has no intrinsic value right now since it gives you no discount to the current price of $13. However, it will have time value since there’s a chance that XYZ will rise above $14 in the next two months, and your option would then have intrinsic value. The option’s time value represents the possibility that the option will have intrinsic value at some point before it expires. 

As you’d expect, time value makes up a smaller percentage of the option price when the option is closer to expiry. 

When an option is far from expiry, a long period of time is available for market conditions to potentially work in the option buyer’s favour. Time value is higher when an option is further from expiry, but time value declines quickly as expiry approaches.

The erosion of the time value portion of the option's price is a challenging aspect of options trading. As an option nears expiration and time till expiry decreases, the market is much less willing to pay a high price for time value. 

Time erosion doesn't occur in a straight line. It’s less dramatic in the earlier months of an option’s life and becomes more pronounced, with a greater impact on the option’s price, as the option nears expiry. 

Buyers of longer-dated options will initially have less time value erosion to contend with than buyers of shorter-dated options. Of course, as time passes, longer-dated options become shorter-dated options that eventually face the same challenge of rapid time value erosion.

Overall, the price of your option can be expressed as: intrinsic value + time value + some additional value from lesser factors. The lesser factors are volatility, dividends and the current level of interest rates, which are explained later in this article.

There are several other factors that contribute to an option's price. However, compared to intrinsic value and time value, they usually play a minor role. We’ve included them here, so you have a complete understanding of options pricing.

Volatility describes the amount of change in the price of an asset over a certain time period. The more the price of a stock moves up or down over a given period, the higher its volatility. 

Implied volatility describes how much traders believe the price of a stock will fluctuate in the future. It’s “implied” because it represents what traders expect for future volatility, rather than simply considering past volatility.  

Higher implied volatility translates to a higher option premium. An upcoming event like a company’s earnings release, when it occurs before the option’s expiry date, can increase implied volatility. You can imagine why this happens — this event increases the likelihood that the stock will experience a big move, to the upside or the downside. 

When a stock price is currently or has recently been volatile, options on that stock will have higher implied volatility. Traders are factoring in the idea that this volatility could continue. Bigger stock price fluctuations mean a greater chance that the option’s intrinsic value will substantially increase or decrease. As a result, option premiums for both calls and puts increase.

The underlying stock's dividends will also have a small but measurable effect on option premiums.

In general, when the underlying stock’s dividend is relatively high, call option premiums will be lower and put option premiums will be higher. This is because the stock price is expected to decline by the amount of the dividend on the ex-dividend date.