Options Pricing

Options Trading Guide for Beginners

Option Pricing Overview

Option prices follow the law of supply and demand. While option writers are responsible for supplying contracts, option buyers determine how appealing it is to own a particular option.

If we’re selling a contract, we should always be thinking: “How much should I charge for taking on the risk of assignment?” After all, option holders fulfill trades that benefit the option holder at their own expense. Option exercise would require us to either buy shares from them at a higher price or sell shares to them at a lower price.

On the other side of the trade, option buyers want to generate profits with as little money as possible. When we reduce our costs, we increase our profit or leverage potential, allowing us to generate higher returns with less capital.

Since option traders ultimately determine the price, there are times when they may misprice options. Therefore, we may benefit from any discrepancies in option pricing if we know how to calculate an option’s fair value.

At the end of this section, you will be able to:

Understand bid, ask, and spreads
Calculate and differentiate intrinsic/extrinsic value
Understand what factors influence option prices

Bid and Ask Prices

An option’s bid price – the highest price that traders are willing to pay for a contract – increases with demand. When demand is high, option buyers will outbid each other, attempting to acquire the option first.

An option’s ask price – the lowest price at which traders are willing to sell their contract – decreases with supply. As the supply of a particular option increases, option sellers compete to offer lower prices and sell their contracts first.

Although we usually see the option’s price as a single number, it reflects the average between the bid and ask prices.

Note that the ask price shown can never be lower than the bid price shown. If a seller tries to sell at $9 when the bid price is currently $10, they will sell at $10. If a buyer tries to bid $15 when the ask price is $11, they will buy at $10. Once a bid exceeds an ask price, a transaction occurs.

The difference between the bid and ask prices is the bid-ask spread. Large spreads may even allow us to profit from ‘scalping’ or ‘trading the spread.’ This strategy involves making small profits from exploiting the price discrepancy between the bid and ask prices.

At a bid price of $10 and ask price of $11, we could trade the spread by buying at $10.05 and selling at $10.95. This example is only for illustrative purposes, as the spread is usually smaller.

Option Valuation

Although supply and demand ultimately dictate option prices, theoretical models can tell us a fair price for our contracts. Learning to price options will allow us to take advantage of mispriced options and potentially increase our profits.

The simplest model that tells us how an option is worth, or its premium, is the sum of its intrinsic and extrinsic value. Whereas an option’s intrinsic value indicates how much profit an option can generate, the extrinsic value represents how likely it will become profitable.

Intrinsic Value

An option’s intrinsic value is what we would earn from exercising the option. In other words, it tells us the option’s inherent worth at any given moment in time.

We can determine the intrinsic value by calculating the potential earnings from exercising the contract. If the option is ineligible for exercise, we wouldn’t have earnings, and therefore have an intrinsic value of $0.

Also, note that we would buy at the strike price and resell at the share price for call options. For put options, we would buy at the share price and resell at the strike price.

For example, exercising a $10 call option with a $15 underlying ($5 ITM) allows us to buy at $10 and sell at $15. We would earn $5 per share on 100 shares, for a total intrinsic value of $500.

A $30 put option with a $20 underlying would have an intrinsic value of $1000.

Intrinsic value only determines the potential earnings from exercising the option. If we wanted to calculate profit, we must also account for the premium to acquire the option.

Since intrinsic value tells us the immediate profit of exercising an option, it only applies to in-the-money or at-the-money options. Since we cannot exercise out-of-the-money options, they have no intrinsic value.

Options deep ITM have more intrinsic value, while ATM options have little to none. At expiration, ITM options have reached maximum profit potential, so the premium consists solely of its intrinsic value.

Extrinsic Value

Extrinsic value is the part of the premium that covers the seller’s risk of assignment. Option writers charge higher premiums for options with a higher likelihood of exercise.

We can calculate the extrinsic value by subtracting the intrinsic value from the option premium.

Since time is the most significant factor that increases the risk of options assignment, we sometimes refer to extrinsic value as time value. An option that has a longer expiry will have more opportunities to go ITM. Therefore, an option with more time to expiration has a greater extrinsic value.

Higher implied volatility also increases the extrinsic value. A volatile underlying stock is more susceptible to price movements, increasing the chance of the option going ITM. Increased volatility can result from general market conditions or when the company releases earnings reports.

Before options expire, the extrinsic value makes up a significant portion of the option premium. Even OTM options aren’t worthless because there’s a chance they’ll become profitable in the future.

An option’s extrinsic value increases when it is more likely the underlying stock will cross the strike price and go ITM. Therefore, options whose underlying is closer to the strike price will have a higher intrinsic value. It also stands to reason that the further away an option is from its strike price, the less extrinsic value it has.