How Are Options Priced?

By Ashley Moore, Associate Editor, Money Morning • February 17, 2017

There are three factors that go into how options are priced.

• Intrinsic value is the distance between the current price of the underlying security and the strike price of the option.
• Time value is the value placed on the option based on how much time is left before expiration. The farther you are from the expiration date, the more expensive the option will be.
• Volatility is the amount of uncertainty about the underlying security. The more uncertainty concerning the movement of the underlying's price, the higher the volatility premium.

The premium you pay to purchase an option = intrinsic value + time value + volatility.

This means that an option that has a strike price well below the market price of the security (for a call option) with a year to expiration and an uncertain future will be very expensive. That's because you're paying to be able to buy the underlying security at lower than market price. You are also paying to have a longer time to sell or exercise the option. Lastly, you are paying for the unknown factors that could push the stock price much higher.

Pricing options is pretty straightforward once you get the hang of it. To help you, we put together a completely free "How To" guide for options trading.

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