Option pricing: the intrinsic and time values of options explained
Option pricing can be complicated, as it depends on several key factors. Here, we unpack the two key principles of how options’ premiums are derived. Learn how options are evaluated and what affects price movements.
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How is an option’s price calculated?
An option’s price is often calculated using complex mathematical processes such as the Black-Scholes and Binomial pricing models. In this article, however, we’ll only focus on how the price of options – called the premium – consists of an option’s intrinsic and time value.
- Intrinsic value is the relationship between the strike price and the market level of the underlying assets. The deeper in the money (ITM) the option is, the higher the premium will be
- Time value is the period until the option’s expiration date. The further away the expiration, and the higher the volatility of the asset, the higher the premium
What is intrinsic value in options pricing?
Intrinsic value in options pricing is the difference between the strike price and the current asset price. Basically, it’s the value of the options contract if it were exercised today.
Intrinsic values of call options are calculated as follows:
Intrinsic value of put options are calculated as follows:
What is a strike price, in the money and out of the money?
- A strike price is the predetermined price at which a contract can be exercised
- In the money (ITM) means that the underlying asset has breached the option’s strike price
- Out of the money (OTM) means that an option contract doesn’t have intrinsic value because the underlying asset hasn’t reached the value of its strike price – it’ll expire worthless
Example of intrinsic value
The table below shows option premiums from a sample of mid-prices for call options on the FTSE 100 for different expiry months (the underlying price is assumed to be 6220).
|Option strike price
If we compare the February 6200 call with the February 6350 call, we can see that the 6200 call is priced at 105, whereas the other is only worth 44.
Bearing in mind that the market level is at 6220, the right to exercise a call at a strike price of 6200 is more desirable than the right to buy at the higher price of 6350. Consequently, the premium is higher.
But why is the 6200 call priced at 105? The right to buy at 6200 when the market is at 6220 must be worth at least 20, which explains a portion of the premium. This is its intrinsic value. It measures how much of the options contract is immediately valuable.
But, two questions remain. Where does the 85 points of the premium come from? Secondly, the strike price of the 6350 call is above the current market level – so the option is OTM but has no intrinsic value. So why does it still have a value of 44? The answer lies in time value, which we explain below.
What is time value in options pricing?
Time value in options pricing refers to the contract’s extrinsic value. It’s based on the expected volatility of the underlying asset’s price and the time until the option's expiration date.
This means that if the option contract has more time before expiration, it has a higher probability of being in the money.
Recalling that the market level is assumed to be 6220 in this example, in the below table, the 6150 and 6200 call options alone have intrinsic value. The others only have value because there’s a chance that the price of the underlying may change between now and the expiry, and that they will acquire intrinsic value at or before expiry.
Options and time to expiry
The amount of time to the expiration date of an options contract has bearing on the premium. That is, the longer the time until expiry, the greater the probability that the option will become in the money and have intrinsic value.
As the expiry date draws closer, the time value of the option drops – but this is in a non-linear fashion. The option only loses one-third of this value in the first half of its lifespan; then it loses two-thirds in the second half. This is called time decay.
Options and market volatility
Volatility in the market represents the fluctuation of the price. When an asset’s price deviates significantly from the mean over a short period of time, it’s considered to have high volatility. Conversely, when there’s very little movement in the price, it has low volatility.
External conditions influence the market to show instability and volatility. For example, at times of emergency or radical changes, such as wars, volatility can increase dramatically. If this happens, an options premium will increase accordingly.
Determining how volatile a market is going to be in the future is tricky. Typically, options traders make assumptions about the future volatility of a market by evaluating the historic volatility.
In such conditions, the higher the volatility, the higher the premium will be. The opposite is also true. In times where volatility is low, the premium will be lower.
Interest rates and dividends in pricing options
The price of options is also influenced by interest rate fluctuations, as well as dividends – in the case of share options. Despite the fact that interest rates affect options pricing, the change is relatively low in comparison to changes caused by volatility in the market.
An increase in interest rates will cause the call premiums to go up and the put premiums to decrease. Any changes to interest rates will affect option valuation, which will have an impact on the price of the underlying asset, the strike price, volatility in the market, and dividends paid out.
Dividends have an impact on the option premium through its effect in the underlying stock price. There will be a direct impact on the share price when the stock starts trading without the value of the next dividend payment.
The option price anticipates the payment of dividends months in advance before the date is announced. Then the price is calculated based on the projection
How to trade options with us
With us, you can trade options on a wide range of markets such as forex, indices and commodities. We offer daily, weekly, monthly and quarterly options. If you trade options with us, you’ll do so using spread bets or CFDs.
Follow these steps to trade options:
- Learn more about options and what influences the movement of options prices
- Decide on the best trading strategy
- Create an account with us or log in to your existing account
- Choose an underlying asset to trade and take steps to manage your risk
- Open and monitor your first position
Note that spread betting and CFD trading is inherently risky, as you’ll be trading on leverage. This means that you’ll open a position using a deposit (margin), but that your profits and losses will be based on the full position size.
In other words, gains and losses will be magnified and you could end up losing a lot more than your deposit. Always take steps to manage your risk.
Options pricing summed up
- Option pricing is influenced by its intrinsic value as well as the time to the expiry date
- The deeper in the money an option is, the higher its premium
- An option that’s further out from expiry will also have a higher premium
- To trade options with us, you’ll use spread bets and CFDs to buy and sell either call or put options
- Other external factors that influence the option pricing include interest rate fluctuations and dividends
This information has been prepared by IG, a trading name of IG Markets Limited. In addition to the disclaimer below, the material on this page does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. IG accepts no responsibility for any use that may be made of these comments and for any consequences that result. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. Any research provided does not have regard to the specific investment objectives, financial situation and needs of any specific person who may receive it. It has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such is considered to be a marketing communication. Although we are not specifically constrained from dealing ahead of our recommendations we do not seek to take advantage of them before they are provided to our clients. See full non-independent research disclaimer and quarterly summary.