Option Pricing

The price of an option can be broken down into two parts: extrinsic value and intrinsic value.

Intrinsic Value

Intrinsic value is the portion of the option that can be realized if the option is exercised. Therefore, only in-the-money options have intrinsic value.

Consider the following example:

Underlying: YUM

Underlying Price: $34

Type: Call Option

Strike Price: $25

Today's Date: 24th of September

Expiry Date: 3rd Friday in December

Now, imagine that this call option is currently trading at $5. Let's look at its intrinsic value: the value of the option that, if exercised, would result in a profit. We know that the call option's strike price is $25 and with YUM trading at $34 it is already worth at least $9. If we choose to exercise our call option we would get the YUM stock at $25 a share (our agreed upon strike price) and turn right around and sell the YUM stock in the market for $34 a share, which is the $9 profit (price difference). This is intrinsic value and the reward for predicting where a stock is likely to be in price further out in time.

Extrinsic Value

When an option is trading at more than the intrinsic value, the difference is known as extrinsic value or time value. Looking at the previous example, we have already determined that the option is worth at least $9 - its Intrinsic Value. However, it is actually trading at $11. The remaining $2 is called Extrinsic Value and represents the markets view of how far the underlying could trade by the time the contract expires.

An option that has no intrinsic value is said to be out-of-the-money (OTM) and if you exercised that option you would actually lose money. Using the same stock above but with a different scenario we have YUM trading at $24 a share so our call option, which gives us the right to buy the stock at $25 a share would be OTM. If we exercised the call option we would pay $25 a share for the stock when in reality we could buy the stock in the market for $24 a share, leaving us with a loss of $1 per share.

So, the call option has zero intrinsic value yet its price in the market is $2 and represents the time value in the option, which expires on the third Friday of December. We have a little over 3 months for YUM to get to our strike price of $25 and actually need the stock to go even higher to cover the cost of our option. This is known as our break even price and is the minimum price we would need YUM to get to by expiration at the latest. Let's assume we paid $5 for the option so if we need YUM to get to our strike price of $25 + $5 for our option cost and that would equal YUM getting to $30 a share. At this point we have covered the cost of our trade and could consider exercising the option or selling it back to the market.

It is also important to understand the Greeks of options as they are all variables that can have an impact on the value of puts and calls. More information can be found by [clicking here].