An option price is the value of an option contract. The option price is determined by the extrinsic and intrinsic value of the option contract.
What is an option?
- Option price is the value of an option contract.
- The option price is impacted by intrinsic value and extrinsic value.
- Intrinsic value is determined by the difference between the strike price of the option contract and the underlying security’s current market price.
- Extrinsic value is determined by the amount of time until the option contract expires and the volatility in the underlying security’s market price.
Options are contracts that allow investors to buy or sell securities at a predetermined price (known as a strike price) in the future. However, the option price is distinct from the price of the underlying security.
Two main factors determine an option’s price. The first is its intrinsic value, which is the difference between the option’s strike price and the current market price of the underlying security. For example, an investor purchases a call option for stock A at a strike price of $5. This means they bought a contract that will allow them to buy shares of stock A at $5 per share at any time before the contract’s expiration. If the current market price of stock A is $10, this gives the call option an intrinsic value of $5 ($10 current market price, $5 option strike price) per share. The higher the intrinsic value of an option contract, the higher the value its option price.
The next factor is the extrinsic value of an option. Extrinsic value is often interpreted as time value. The further an option is from its expiration date, the more extrinsic value it is expected to have. This is because it allows more time for the underlying security to change in value. An option will have no extrinsic value on the day of its expiration, at which point the value of an option will depend entirely on its intrinsic value.
Extrinsic value can increase the option price even if there is no intrinsic value. This is because the extrinsic value is impacted by the underlying security’s price movements and the amount of time until expiration. For example, if we purchased a call option that expires two years from now for stock B at a strike price of $20, and if stock B’s current price is $10, then the option does not have any intrinsic value as the current price is lower than the strike price. However, two years is a lot of time for the stock price to change, so the option has some extrinsic value. Depending on stock B’s volatility and growth, an investor can still receive a return even if the market price doesn't exceed the strike price. On expiration day, however, the extrinsic value will become zero. If the underlying security’s market price is also under the strike price of the call option, then we also have zero intrinsic value. This will result in the option expiring as worthless, with the investor losing all the invested money in the option.
Depending on the type of option an investor purchases, the relationship between the underlying security’s price movements and options price can vary. In the above example, we discussed buying a call option in which rising stock prices will increase the option price. However, for bought put options, a decreasing stock price will increase it price.