A lot more goes into putting an accurate price tag on an options contract than many investors probably realize. There are several factors that go into the pricing of options, and for the unfamiliar, it can be slightly intimidating.
The most widely used options pricing model is the Black-Scholes model. This takes into account the value of the underlying security, the option's strike price, volatility, and time to expiration to assess the value of options.
While this might seem like a lot to keep track of, as you'll see, each factor is fairly easy to understand on its own. So let's take a look at each of the factors that go into pricing options.
Intrinsic value is simply the measure of an options value if it were to be exercised today. It is a measure of how much the contract is "in the money" or how much profit is currently available to the investor.
To calculate intrinsic value for a call option, you simply subtract the strike price from the current trading price of the underlying security. For example, if you own XYZ calls with a strike price of $50 and the stock is trading at $55, the intrinsic value is $5. For puts, you subtract the stock price from the strike price. So if you owned XYZ puts with a strike of $60 and the stock is trading at $55, the intrinsic value of your option is $5. (Note: Since one option covers 100 shares, the actual intrinsic value of an option that is $5 in the money is $500 ($5 x 100).)
Time value is a much greater element in options investing than it is in stock investing. An investor can buy a stock and hold it for 20 years if they so choose, whereas options have finite life spans since they eventually expire. The further away from expiration an options contract, the greater chance you have for profit. Thus, the higher an option's time value. For example, if it's May and you're considering the purchase of XYZ $50 calls expiring in June or XYZ $50 calls expiring in August, the August contract will be more expensive because you have more time for the trade to become profitable.
To calculate time value on an option, we subtract intrinsic value from the option's price. For example, say XYZ is trading at $40 per share and a call option at a $35 strike price costs $7.50. Of the $7.50, $5 is the intrinsic value, while the remaining $2.50 is the time value.
In addition to the length until the option expires, an option's value is also dependent on a stock's volatility. Stocks that don't move much will have a lower time value on their options. On the other hand, highly volatile stocks will have higher time value.
There are two types of volatility for which formulas can be applied. Historical volatility is the use of a security's past price movements to get a sense of where it might be headed in the future. Implied volatility is a theoretical concept that helps place a price on options currently being traded. It is a measure of what traders might expect volatility to be going forward. Essentially, implied volatility is a sentiment indicator.
A Better Grasp of Options Pricing
The pricing of options does depend on more factors than just those detailed above -- not the least of which are basic supply and demand. However, for those just starting out in the field of options, this should give you a better grasp of just how and why an option's price moves.