Options prices are made up of intrinsic and extrinsic value.

Intrinsic value is the amount the stock price is above the strike price.

Extrinsic value is also known as time value and the most important component is implied volatility.

Implied volatility is derived from the options price and tells the trader the demand for the option as well as the market’s forecast for the real volatility of the stock.

Changes in implied volatility can have a dramatic affect on an option’s price.

Time decay is against option buyers and works for option sellers.

Option buyers want to buy low and sell high, ideally supported by increasing implied volatility.

So you bought a call option prior to earnings, with the expectation that the stock price would go up. And go up it did! But your call option didn’t gain in value. Now, as you hold onto it and ponder what could have happened, you start losing money. What is going on? What you are seeing is the result of the various factors — other than the price of the underlying — that help determine an options price. Foremost are implied volatility and time decay.

Factors in Options Pricing

There are several factors that determine the price of an options contract. Most traders are trying to take advantage of directional moves in the underlying stock, and that is the primary driver of the price of an options contract, especially its intrinsic value. But the extrinsic value of an option, also known as its time value, is affected by time left before expiry, as well as the option’s implied volatility. And there are several other factors. Traders must understand all of the things that can influence the price of an option in order to understand their risks as well as have the highest probability of profit.

The following, known as option greeks, are used to measure the sensitivity of options price:

Options are influenced by the underlying price (delta )

• Delta gives the change in the options price given a $1 change in the underlying. An option with a delta of .5 will change $.50 for a $1 change in the underlying.
• Example: You buy an XYZ $40 call for $1.00 with a delta of .5 and XYZ at $40. If the stock price goes up to $41, the call should be worth roughly $1.50.

Options are influenced by time decay (theta )

• As options are expiring assets, the entire extrinsic value is exposed to time decay, which will, all else held equal, eat away at the value of an option every day.
• The amount of time decay will increase as the option approaches expiration.
• An option has no time value at expiration and is only worth its intrinsic value.
• Theta is negative for long options, as they lose value due to time decay.

Options are influenced by implied volatility (vega )

• Vega gives us an approximation of the amount that the options price will change given a 1% move in implied volatility.
• Implied volatility is the most misunderstood and the most important component of time value. For example, most options traders have had the experience of buying an option, being right on the direction of the underlying stock, and still losing money.

Options are also influenced by interest rates (rho ) and the sensitivity to the change in the delta (gamma ). Gamma, which is derived from delta, tells the amount that the delta will change given a $1 change in the underlying stock.

Option Price and Value

Premium

For the right to either buy (call) or sell (put) the underlying security on or before the expiration date, the buyer of an option will pay a premium, the options price. This is known as the debit, and is the maximum risk. As the seller of the option you will receive a premium as net credit, but you will be obligated to buy (when short a put) or sell (when short a call) the underlying shares if the options contract is exercised. Cash will be held as a margin on a short position.

In the money (ITM), At the money (ATM), Out of the Money (OTM)

The strike price, or exercise price, of an option determines whether that contract is in the money, at the money, or out of the money. If the strike price of a call option is less than the current market price of the underlying security, the call is said to be in the money, because the holder of this call has the right to buy the stock at a price which is less than the price he would have to pay to buy the stock in the marketplace. Likewise, if a put option has a strike price that is greater than the current market price of the underlying security, it is also said to be in the money because the holder of this put has the right to sell the stock at a price which is greater than the price he would receive selling the stock in the market. The converse of in the money is, not surprisingly, out of the money. If the strike price equals the current market price, the option is said to be at the money.