Intrinsic Value, Option Premium
Option Premium can be best described as the cost of an option. To many, understanding options premium can be intimidating. While it may seem like there are many variables that go into premium calculation, the reality is there are two parts that make up the value. Moreover, there are three distinct variables affecting the value of an option’s price.
Before we get too far along, let’s recap some important options details you need to understand first.
Option premium is calculated by adding the intrinsic value and extrinsic value of the option. If you’re not familiar with these two terms… let me discuss them briefly.
Intrinsic Value is the value of an option that’s already built into it at present time. An example would work best in explaining intrinsic value…
Let’s say you’re looking at a quote for McDonalds (MCD) January $100 Calls and the current price of MCD stock is $102. At the time you read the options quote, you’ll find $2.00 of the price is intrinsic value. Basically, intrinsic value expresses how much the option is already in the money. The point being, the option is currently worth $2.00 at the time of expiration.
Extrinsic Value is a bit more complicated. Earlier I said there were three distinct variables affecting an option premium. Extrinsic value is primarily what is affected by these variables. Extrinsic value is the part of the option considered the “risk premium”. This portion is affected by time decay, distance to the underlying assets strike price, and the volatility of the underlying asset.
For an example of extrinsic value, we’ll use the same McDonalds January $100 Calls…
Let’s say MCD is trading at $102 as in the example above. We already know there is $2 of intrinsic value in the options price. But the total price of the Call option is $3.00. That would tell us that $1 of the options pricing is the extrinsic value, or risk premium.
To understand how the extrinsic value is calculated requires quite a bit more reading than we’ll cover here. But as a basic guideline, the premium of an option is calculated by using what’s known as the Black-Scholes model.
In this model, it combines the time remaining until expiration, the strike price, prevailing interest rate, the current price of the underlying asset, and the option’s volatility. And those same variables will always be in the equation for calculating the extrinsic value of an option.
To recap, the option premium takes into consideration a number of variables that make up the intrinsic value and extrinsic value of an option. While it may seem quite complex, the variables used to calculate the premium remain relatively unchanged. And knowing how options are priced can help you make better options trades.
Category: Options Trading Basics
