Understanding Option Pricing
Call Option
Intrinsic Value = Underlying Stock's Current Price – Call Strike Price

Put Option
Intrinsic Value = Put Strike Price – Underlying Stock's Current Price

The intrinsic value of an option reflects the effective financial advantage that would result from the immediate exercise of that option. Basically, it is an option's minimum value. Options trading at the money or out of the money have no intrinsic value.
The time value of options is the amount by which the price of any option exceeds the intrinsic value. It is directly related to how much time an option has until it expires as well as the volatility of the stock. The formula for calculating the time value of an option is:
Time Value
= Option Price – Intrinsic Value

The more time an option has until it expires, the greater the chance it will end up in the money. The time component of an option decays exponentially. The actual derivation of the time value of an option is a fairly complex equation. As a general rule, an option will lose onethird of its value during the first half of its life and twothirds during the second half of its life. This is an important concept for securities investors because the closer you get to expiration, the more of a move in the underlying security is needed to impact the price of the option. Time value is often referred to as extrinsic value.
The effect of volatility is mostly subjective and it is difficult to quantify. Fortunately, there are several calculators that can be used to help estimate volatility. To make this even more interesting, there are also several types of volatility  with implied and historical being the most noted. When investors look at the volatility in the past, it is called either historical volatility or statistical volatility. Historical Volatility helps you determine the possible magnitude of future moves of the underlying stock. Statistically, twothirds of all occurrences of a stock price will happen within plus or minus one standard deviation of the stocks' move over a set time period. Historical volatility looks back in time to show how volatile the market has been. This helps options investors to determine which exercise price is most appropriate to choose for the particular strategy they have in mind.
Implied volatility is what is implied by the current market prices and is used with the theoretical models. It helps to set the current price of an existing option and assists option players to assess the potential of an option trade. Implied volatility measures what option traders expect future volatility will be. As such, implied volatility is an indicator of the current sentiment of the market. This sentiment will be reflected in the price of the options helping options traders to assess the future volatility of the option and the stock based on current option prices.
Summary
A stock investor who is interested in using options to capture a potential move in a stock must understand how options are priced. Besides the underlying price of the stock, the key determinates of the price of an option are its intrinsic value  the amount by which the strike price of an option is inthemoney  and its time value. Time value is related to how much time an option has until it expires and the option's volatility. Volatility is of particular interest to a stock trader wishing to use options to gain an added advantage. Historical volatility provides the investor a relative perspective of how volatility impacts options prices, while current option pricing provides the implied volatility that the market currently expects in the future. Knowing the current and expected volatility that is in the price of an option is essential for any investor that wants to take advantage of the movement of a stock's price.
The most influential factor on an option premium is the current market price of the underlying asset. In general, as the price of the underlying increases, call prices increase and put prices decrease. Conversely, as the price of the underlying decreases, call prices decrease and put prices increase.
If underlying prices ...

Call prices will ...

Put prices will ...

Increase

Increase

Decrease

Decrease

Decrease

Increase

Expected Volatility
The greater the expected volatility, the higher
the option value

The strike price determines if the option has any intrinsic value. Remember, intrinsic value is the difference between the strike price of the option and the current price of the underlying. The premium typically increases as the option becomes further inthemoney (where the strike price becomes more favorable in relation to the current underlying price). The premium generally decreases as the option becomes more outofthemoney (when the strike price is less favorable in relation to the underlying).
Premiums increase as options become further
inthemoney

Time Until Expiration
The longer an option has until expiration, the greater the chance that it will end up inthemoney, or profitable. As expiration approaches, the option's time value decreases. In general, an option loses onethird of its time value during the first half of its life and twothirds of its value during the second half. The underlying's volatility is a factor in time value; if the underlying is highly volatile, one could reasonably expect a greater degree of price movement before expiration. The opposite holds true where the underlying typically exhibits low volatility; the time value will be lower if the underlying price is not expected to move much.
The longer the time until expiration, the higher
the option price

The shorter the time until expiration, the lower
the option price

Interest Rate and Dividends
Interest rates and dividends also have small, but measurable, effects on option prices. In general, as interest rates rise, call premiums will increase and put premiums will decrease. This is because of the costs associated with owning the underlying; the purchase will incur either interest expense (if the money is borrowed) or lost interest income (if existing funds are used to purchase the shares). In either case, the buyer will have interest costs.
If interest rates ...

Call prices will ...

Put prices will ...

Rise

Increase

Decrease

Fall

Decrease

Increase

If dividends ...

Call prices will ...

Put prices will ...

Rise

Decrease

Increase

Fall

Increase

Decrease

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