Time Value
Time value is the amount by which the price of the option exceeds its intrinsic value.
For example, that XYZ November 100 call, with XYZ trading at 102, might be selling for 4-1/2. Thus, there is 2 points in intrinsic value and 2-1/2 points in time value. If XYZ were trading at 99, and the price of the option was 2, there would be no intrinsic value and 2 points in time value. If an XYZ November 100 put was priced at 3 and XYZ stock was trading at 99, there would be 1 point in intrinsic value and 2 points in time value.
If an XYZ November 100 put was trading at 2 and XYZ stock was priced at 101, there would be 2 points in time value and no intrinsic value. The time value premium of an option declines as the expiration date approaches.
Intrinsic Value + Time Value = Option Price
Factors Influencing the Price of an Option
There are four major factors which determine the price of an option. They are:
The price of the underlying stock. The strike price of the option itself. The time remaining until the option expires. The volatility of the underlying stock.
Two less important factors in determining the price of an option are: 1. The current risk free interest rate. 2. The dividend rate of the underlying stock.
The primary influence on an options price is the price of the underlying security. On expiration day, if I own one XYZ November 100 call, and XYZ is trading at 95, my call is worthless. On the other hand, if I own one XYZ November 100 call, and the price of XYZ on expiration day is 102, my call is worth at least 2 points.
An options price decays each day it is in existence. Further, the closer the option gets to expiration, the faster it decays. The rate of decay is related to the square root of the time remaining. An option with two months remaining decays at twice the speed of a four month option etc.
Volatility
The volatility part of the pricing model is a measure of the range the underlying security is expected to fluctuate over a given period of time. The measurement of volatility is the standard deviation of the daily price changes in the security. The more volatile the underlying security, the greater the price of the option.
There are two different kinds of volatility. There is historical volatility; and there is implied volatility.
Historical volatility estimates volatility based on past prices.
Implied volatility starts with the option price as a given and works backward to ascertain the theoretical value of volatility equal to the market price minus any intrinsic value.
Option Pricing Models
There are many different option pricing models in practice. However, the original breakthrough was in the Black-Scholes model. It was a model for pricing options before options were widely traded.
The original Black Scholes model worked primarily for European style options. However, it has been modified to work with American style expiration.
Since then, several variations have been developed.
The Cox Rubenstein model and Yates models are two widely used models for pricing American style options. There are other binomial option pricing formulas. And some options are priced according the cost of the hedge for the specialist/market maker.
