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Option Price Components

What drives option prices.

Break down premiums into intrinsic and time value.

Premium Structure

An option's premium is the total price paid to acquire the option contract. 

This premium is composed of two parts: intrinsic value and time value. 

The intrinsic value represents the immediate financial advantage of exercising the option, while the time value reflects the additional worth based on the potential for favorable price movements before expiration. 

The premium is calculated as Intrinsic Value plus Time Value. 

This breakdown helps explain how option prices are determined and why they change.

Intrinsic Value

Intrinsic value is the value of an option if it were exercised immediately.

For call options, it is calculated as the greater of zero or the stock price minus the strike price.

For put options, it is the greater of zero or the strike price minus the stock price. Intrinsic value cannot be negative and represents the immediate benefit of exercising the option. 

It is independent of time to expiration and changes dollar-for-dollar with the underlying asset when the option is in-the-money.

Delilah Calculates Intrinsic Value

Delilah is considering a call option on TechCorp with a strike price of $50. 

The stock is currently trading at $55. She calculates the intrinsic value as $55 - $50 = $5. 

This means the option is in-the-money and has an immediate exercise value of $5 per share. 

If she were evaluating a put option with the same strike price and stock price, the intrinsic value would be $50 - $55 = -$5, which is zero. 

Therefore, the put option is out-of-the-money with no intrinsic value.

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Time Value

Time value is the portion of the option's premium above its intrinsic value, reflecting the probability of gaining value before expiration.

It’s highest when at-the-money, as the price could move in either direction. 

However, deep in-the-money options have limited chances for further significant gains or losses, as the next price movement’s impact is smaller. 

Thus, time value decreases with deeper moneyness and as expiration nears. Volatility also plays a key role, influencing potential price fluctuations.

Time Decay and Time Value

Time decay refers to the reduction of an option's time value as the expiration date approaches. 

This decay is not linear; it accelerates as the option gets closer to expiration. 

As time diminishes, there is less opportunity for the underlying asset's price to move favorably, reducing the option's time value. 

Traders holding options need to be aware of time decay, as it can erode the premium paid even if the underlying asset's price remains unchanged.

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