Volatility and Options Pricing - How is Option premium priced?

Option Pricing & Options Premium

Writing an Option is an obligation for the seller of the option to sell the underlying (Stock, Commodity or Future) at the strike price. The writer of call option or a put option is at a 'risk' because of possible price fluctutions. For example, if you write a call option, then any price rise in the underlying will result in loss for you. As a compensation for this risk, the persion buying options pays a premium to the writer. The Buyer of the option on the other hand is not exposed to risk or uncertainty because he has the option but not the obligation to buy (in case of call option) or sell (in case of put option). The premium of the options therefore hides a lot of factors that may contribute to the risk to which the writer of the options is exposed. In this post will discuss the factors which influence Options Pricing.

If you are new to futures and options you may want to read my post on "stock options example explained" or Covered Call - Options Strategy.

How are Commodity and Stock Options Priced?
Factors affecting options pricing

The price of an options premium can be though of as made of two parts Intrinsic Value of the Option and the Time value of the Option. In other words we can think of

Premium or Option Price = Intrinsic Value + Time Value

A call option is call in the money option if its strike price is below the current market price of the underlying. In this case the intrinsic value of the call options is defined as the difference between the current price and the strike price. Intrinsic value is equal to the money that you would gain if you were able to immediately exericse the option. Similarly we have the concept of at the money, and out of the money call option and analogous concepts for put options summarized by the following table.

Type of Call / Put Option	Definition / Condition on Strike Price	Intrinsic Value of the Call/Put Option
In the Money Call Option	Option Strike Price > Current Price	Intrinsic Value of the Call Option = Current Price - Strike Price
At the Money Call Option	Option Strike Price = Current Price	Intrinsic Value of the Call Option = Zero
Out of the Money Call Option	Option Strike Price > Current Price	Intrinsic Value of the Call Option = Zero
In the Money Put Option	Option Strike Price > Current Price	Intrinsic Value of the Put Option = Strike Price - Current Price
At the Money Put Option	Option Strike Price = Current Price	Intrinsic value of the Put Option = Zero
Out of the Money Put Option	Option Strike Price > Current Price	Intrinsic value of the Put Option = Zero

The remaining component of the options price, i.e. the Time value is a bit more complicated to understand and it depends on a variety of factors listed in the following table.

Three main Factors affecting Time Value component of Options Pricing.

Factor affecting Time Value	Explaination / Effect on Option Price
Volatility	Roughly speaking Volatility is the measure of 'how much the underlying moves'. The more the volatility of the stock or index, the more the risk for the writer of the option and therefore more the time value.
Time Remaining to Expiry date of the Option	The greater the time that is remaining to the expiry date of the option, the more the 'time value' of the option.
Type of Option: American or European	American style Options are those which can be exercised anytime before the expiry date of the option. European style options are those which can be exercised only on the expiry date of the Option. Since American Style Options give more flexibility to the options buyer, their price is more than the European style Options.

More about How is the options price calculated? Black Scholes etc.

I have just mentioned the factors which affect the price of options. If you want an exact formula you can read the wiki post on Black Scholes Formula for Options Pricing. I however think it is not very useful to break your head too much trying to understand the precise formula as it does not give any more insight into options pricing.

There is one more thing that you need to know about options pricing, viz., the concept of Implied Volatility. While calculating 'ideal options price' volatility of the underlying is calculated using historical values, i.e. by observing the price movements in the past. Naturally price movements in the past may not accurately reflect the future price movements. For e.g. according to historical values a stock shows 20% volatility, it may happen that the current price of options premium is more than what you would calculated ideally. It just means that the market expects the stock to show more volatility. This expected volatility reflected in the price of the options premium is called as Implied Volatility. Implied Volatility gives a very good idea of what the market expects in future. Read more about Implied Volatlity.

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Volatility and Options Pricing - How is Option premium priced?