How Does Options Pricing Work?

Options Traders, Options Trading, Options Research, Options Analysis

Option pricing may seem complicated at first, as contract values are derived from a few different factors. Specifically, option premiums are based on the Nobel Prize-winning Black-Scholes model, which considers multiple variables to arrive at a fair price. Specifically, the calculation weighs:

  • The price of the underlying stock, assuming constant drift and volatility
  • The strike price of the option
  • The amount of time until the option expires
  • A constant, risk-free interest rate

The Black-Scholes option pricing model does not account for dividends. In the case of dividend-paying stocks, the pricing formula is adjusted to account for these payouts. Scheduled dividend payments lower the value of call options, and raise the value of put options.

To break it down in very simple terms, option pricing consists of two main components:

  • Intrinsic value
  • Time value (or "extrinsic value")

Only in-the-money options carry intrinsic value, which is equal to the difference between the current stock price and the strike price of the option. The remainder of an in-the-money option's premium is the contract's time value.

Meanwhile, at-the-money and out-of-the-money options have no intrinsic value, so their entire worth consists of time value. Time value is based primarily upon two factors:

  • Time until expiration
  • Implied volatility

Time value will erode at an increasing rate until it finally dwindles to zero upon expiration. This decline in extrinsic value is known as "time decay." So, if an option remains at-the-money or out-of-the-money through expiration, its value will eventually diminish away to nothing.

Upon expiration, an option is worth only as much as its remaining intrinsic value, if any.

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