Fundamentals of Option Pricing

When one begins to consider an option, it is very important to figure out how the premium is calculated. Option premiums depend on a variety of factors including the time left to expiry as well as the price of the underlying security. There are two parts to an option premium: intrinsic value and time value. Consequently, several different factors have an influence on intrinsic and time value.

Intrinsic Value

Intrinsic value is the difference between the market price of the underlying shares at any given moment in time and the exercise price of the option. The following are a couple of examples for call and put options.

Call Options

For example, say MicroCeuticals (MC) April $25.00 call options are trading at a premium of $6.00 and MC shares are trading at $30.00 per share, the option has $5.00 intrinsic value. The latter is true because the option taker has the right to purchase the shares for $25.00, which is $5.00 lower than the market price. Such options, which have intrinsic value, are said to be 'in-the-money'. In this example, the remaining $1.00 of the premium is time value ($6.00 - $5.00).

If the shares of MC were trading at $23.00, intrinsic value would effectively be zero because the $25.00 call option contract would only enable the taker to purchase the shares for $25.00 per share, which is $2.00 higher than the market price. When the share price is less than the exercise price of the call option, the option is considered to be 'out-of-the-money'.

It is important to remember that call options convey to the taker the right, but NOT the obligation to purchase the underlying shares. If the share price is below the exercise price, then it is probably better to purchase the shares on the share market and let the options lapse.

Put Options

Put options work in the opposite way to calls. If the exercise price is greater than the market price of the share, then the put option is in-the-money and possesses intrinsic value. Exercising the in-the-money put option allows the taker to sell the shares for a higher price than the current market price.

For example, an MC April $40.00 put option allows the holder to sell MC shares for $40.00 when the current market price for MC is $35.00. This option has a premium of $5.50, which consists of $5.00 of intrinsic value and 50 cents time value. A put option is out-of-the-money when the share price is above the exercise price, since a taker will not exercise the put to sell the shares below the current share price.

As you may recall, put options convey the right, but not the obligation to sell the underlying shares. If the share price is above the exercise price then it is probably better to sell the shares on the share market and let the option lapse.

It should be noted that when the share price equals the market price, the call and put options are said to be 'at-the-money'.

Time Value

Time value represents the amount that you are prepared to pay for the possibility that the market might move in your favor throughout the life of the option. It represents and extra payment to the writer of the option to offset the risk that the underlying share will move, and result in a loss to the writer. Time value will vary with in-the-money, at-the-money, and out-of-the-money options and is greatest for at-the-money options. As the time of expiry draws near and the opportunities for the option to become profitable decline, the time value decreases. This dilution of option value is termed time decay. Time value does not decay at a constant rate, but becomes more rapid, possibly even exponential, as one gets closer to expiry.

Time value is influenced by the following factors, among others: time to expiry, interest rates, market volatility (which you can quantify using Bollinger Bands), dividend payments, and market expectations.

The time value of an option is greater the longer the time to expiry. The premium will be higher under conditions of high market volatility. Again, Bollinger Bands are a great way to measure market volatility. This is a consequence of the wider range over which the stock or commodity can potentially move. As interest rates increase, call option premiums will be driven up, while put option premiums will be pushed down. Supply and demand will determine the market value of all options. During times of strong demand, premiums will undoubtedly be higher.

Hopefully this article will provide investors and traders considering purchasing or selling options with more information. Although technical analysis is useful in attempting to predict market movement, fundamental analysis of options via the use of the factors described above may provide many traders with benefits as well.

Joshua M. Kunken is Chief Currency Analyst for ForeignMarketWatch.com. His articles have also been featured at ForexTrack.