Lesson 3 – Option Pricing

Is it necessary to know option pricing? Yes, it is necessary to know option pricing because only then will you know whether the amount you pay is fair or not. As real estate investors suggest, you need to be considerate of your purchase. Only during the purchase, your profit is decided. Therefore, when you are not spending a high price on options, you will be able to make a better profit. If you want to succeed in trading or investing in any instrument, you must know how the value is obtained.

In this lesson, we will discuss the components that create premium, option contract, or price. And then, we will learn to differentiate Extrinsic and Intrinsic Value.

If you want to get a clear picture of option pricing concerning influencing factors of the market, the influential factors of an option contract and individual stock price will help you trade or invest.

In the second lesson, Premium Terminology was introduced to you. It is the purchase price for the put or call option contract. Normally, it is the quoted price for shares. It is a discounted or lower value compared to the underlying stock’s purchase.

The premium prices differ as per the supply and demand, just like share prices differ as per the supply and demand. Also, the Option Premium or Price of a contract is obtained from the underlying asset’s value. This includes an index, stock, or commodity. This is why options are named Derivatives.

Also, an option premium has two components:

1) Intrinsic Value

2) Extrinsic or Time Value

Intrinsic Value

An option premium’s value can be calculated using the following formula:

Intrinsic Value + Time (Extrinsic) Value = Premium price 

Now, let’s check each component separately.

So how do you define Intrinsic Value? You can define it by showing the difference between the underlying asset’s price and the option’s strike price.

As mentioned in the table, the ATM strike mentions the level of trading, which is near the current price of a share. When considering Call options, the levels of ITM strike would be trading under the current price of a share. When considering Put options, the levels of ITM strike would be trading above the current price of a share. The main rule is that Intrinsic Value is only in ITM options. This is crucial for understanding the pricing of options.

Another point is that you can’t witness Intrinsic Value being less than zero. Thus, you would be finding the option price’s Intrinsic Value or a value of zero. However, it will never be less than zero.

If there were an intrinsic value for the call option, the current trading price of the stock would be higher than the strike price. Or strike price will be lower than the share price. As for the previous rule, you will realize that this makes sense.

Let’s consider an example to understand better.

In this example, QAN, which is trading at $3.96, will be compared to the call option QAN $3.75. This means that the strike price of a QAN call option is $3.75. If you buy this, you reserve the right, but you don’t get the obligation to purchase the QAN shares, which are at $3.75 before or on the expiration of the contract.

Anyway, the current trading price of the share is $3.96.

Now, let’s check the Price or Premium of the option. First of all, let’s talk about the Intrinsic Value formula.

Intrinsic Value = underlying asset’s price – the option’s strike price 

For this example, the Intrinsic Value of 21 cents is the rate of option premium. From $3.96, deducting a $3.75 strike would give a balance of 21 cents.

As a buyer, if you consider your right to purchase QAN shares, the $3.75 strike price is at which you can purchase them. However, the prevailing market price of the shares would be $3.96. The difference is 21 cents. Therefore, Intrinsic Value would be 21 cents.

Now, let’s assume if this was Call option ITM on QAN, and we are comparing it to Call option OTM.

If we are reviewing Call option QAN $3.75 with QAN trading at $3.36, you won’t witness Intrinsic Value. First of all, the OTM Call strike is $3.75 and is higher than the current price of the share. The call option taker might not think about utilizing the right to purchase QAN shares pricing $3.75 while the current price of the share is at $3.36. This is because purchasing from the open market is cheaper.

When the share price increases by every cent more than the option’s strike price, the value of premium will also technically increase by 1 cent. And this is basically what Intrinsic Value Relationship is. Now, you need to know that when Intrinsic Value increases, it is not necessarily linear. However, this is not the stage that you need to dig deeper because, so far, we’ve covered the basics that you might need when trading or investing.

You are now aware of Call option Intrinsic Value, so let’s move to Put option Intrinsic Value.

Put option Intrinsic Value

This is the opposite of Call option Intrinsic Value. The strike price of the put option should be higher than the current trading price of the stock to get an Intrinsic Value. Just like for call options, the same rule is followed: only ITM put options show Intrinsic Value and will not be lower than zero.

Let’s check an example to understand better.

The current trading price of WOW is at $5.42. If you are to evaluate Put Option $6.00, the Intrinsic Value would be $0.58. This is put strike ITM because the strike level is higher than the share price so that you will witness an intrinsic value. The Intrinsic Value formula is the difference between the current price of the share and the strike price, i.e., 58 cents.

As you are the taker, if you are utilizing the option, you get to enjoy the selling right of the shares pricing $6.00 strike, while the market price is $5.42. This lets you save 58 cents.

Let’s consider the trading rate of WOW is $6.15, and OTM Put option is $6.00, so the current price of the share is higher than strike. Thus, you will not encounter an intrinsic value in the premium or price of a put option. So, the taker can sell the shares at $6.15, which is the market rate. This is better than exercising the selling right at $6.00.

Keep in mind formula for calculating option’s premium or price:

Intrinsic Value + Time (Extrinsic) Value = Premium price

Assume that we have determined the option’s intrinsic value, can decide the price for our options broker, then, we can calculate the Option’s Time (Extrinsic) Value.

So the adjusted formula is:

Time (Extrinsic) Value = Premium price – Intrinsic Value

Both Put and Call options to use this formula.

So before we consider some examples, let’s see what Time Value means.

Time (Extrinsic) Value

An option is termed as “wasting asset.” As you would have already known, option offers the right but doesn’t provide an obligation to sell or buy the underlying asset at a decided price before or on a set date. Due to this component, an option is considered a wasting asset. Also, it has an expiration date.

Along with time, the time value component will reduce. The Time Value defines the amount a trader or investor wishes to pay for the position concerning the profit secured. The option will create higher intrinsic value when there’s more time for expiration and when the option distances ITM. Thus, the option has more value when it is related to more time.

As mentioned, when the option goes away from expiration, the Time Value increases. Anyway, when the option reaches expiration, the decaying of time value will happen at an increasing rate creating zero on the expiration date.

If we consider the QAN example:

If we consider QAN, which is at $3.96 trading, the reviewing rate would be Call option $3.75. We have already mentioned that the Intrinsic Value would be 21 cents, but most probably, price or premium will be higher than 21 cents. So time left until expiration will have a price Value.

For this example, we’ll consider $0.09 was the Time Value. So to purchase QAN call option priced at $3.75, your cost would be 30 cents. For 30 cents/share, you wouldn’t secure the obligation, but the right to purchase shares at $3.75 before or on expiration.

It is wise for us to discuss Time Decay now. However, instead of discussing it in this lesson, we’ll talk about it in the final lesson where advanced concepts will be discussed.

As we said earlier, when the expiration is near, the time value of an option will reduce. Hence, it is referred to as Time Decay. This will impact the option price continually because time doesn’t halt. However, time decay will rapidly increase in the last weeks of the time frame of an option.

The reason is that option has a lower time frame to turn out profitable. The certainty concerning the price of the underlying share is high when the option contract gets closer to the date of expiration. Also, zero would be the Time Value component of the option premium.

Let’s now check examples related to Call options pricing regarding the Time Value and Intrinsic Value.

$3.50 is the FGL share price.

In the first example, the Call option $3.00 has 56 cents of the premium price. So the Intrinsic value is 50 cents when applying the formula discussed. This will have an Intrinsic Value because it is strike level ITM.

You can then deduct the Intrinsic Value from option Premium price to get the Time Value of 6 cents.

At the ITM strike level $3.25, the price of the option is 33 cents. You will encounter 25 cents Intrinsic Value, and so Time Value would be 7 cents.

At the ATM strike level, $3.50, the premium price is 24 cents. However, there will not be an Intrinsic Value. Thus, the whole premium 24 cents is created by Time Value.

As we move into Strike levels OTM, 10 cents would be the premium price of strike $3.75. As this doesn’t have Intrinsic Value, 10 cents would be the Time Value.

Lastly, the OTM strike $4.00 has 6 cents premium price. It doesn’t have Intrinsic Value while 6 cents being the Time Value.

Now you would be able to grasp the concept altogether. Anyway, now, let’s check some pricing examples for a put option to check whether you can calculate Time Value and Intrinsic Value.  

The below example includes the current price of the shares of the WDC group. The trading rate of the shares is $12.50.

As the table above shows, only Put options ITM indicate Intrinsic Value. The Put Strike $13.50 shows a $1.15 premium price at the bottom of the above table. The difference between stock priced at $12.50, and strike price shows the Intrinsic Value of $1.00, leading to Time Value 15 cents.

There is a premium of 75 cents for the strike price of $13.00. This provides the value for Time Value 25 cents and Intrinsic Value 50 cents.

The strike levels, such as $12.00, 11.50, and $12.50, don’t show Intrinsic Value. Thus, the time value is equated by the Premium price paid to buy put options.

So in the 3rd lesson, we have covered components that create premium or price of an option and the difference between Time Value and Intrinsic Value.

In lesson 4, we’ll talk about influencing factors of the price of an option and then introduce pricing models of options to you!