Fundamentals of Option Pricing

When one begins to consider an option, it is very important to figure out how the premium is calculated. Option premiums depend on a variety of factors including the time left to expiry as well as the price of the underlying security. There are two parts to an option premium: intrinsic value and time value. Consequently, several different factors have an influence on intrinsic and time value.

Intrinsic Value

Intrinsic value is the difference between the market price of theunderlying shares at any given moment in time and theexercise price of the option. The following are a couple of examples for call and put options.

Call Options

For example, say MicroCeuticals (MC) April $25.00 call optionsare trading at a premium of $6.00 and MC shares are tradingat $30.00 per share, the option has $5.00 intrinsic value.The latter is true because the option taker has the rightto purchase the shares for $25.00, which is $5.00 lowerthan the market price. Such options, which have intrinsicvalue, are said to be 'in-the-money'. In this example,the remaining $1.00 of the premium is time value ($6.00 - $5.00).

If the shares of MC were trading at $23.00, intrinsic valuewould effectively be zero because the $25.00 call option contractwould only enable the taker to purchase the shares for $25.00per share, which is $2.00 higher than the market price. Whenthe share price is less than the exercise price of the call option,the option is considered to be 'out-of-the-money'.

It is important to remember that call options convey to thetaker the right, but NOT the obligation to purchase the underlying shares.If the share price is below the exercise price, then it is probably better topurchase the shares on the share market and let the options lapse.

Put Options

Put options work in the opposite way to calls. If the exercise priceis greater than the market price of the share, then the put option isin-the-money and possesses intrinsic value. Exercising the in-the-moneyput option allows the taker to sell the shares for a higher price than thecurrent market price.

For example, an MC April $40.00 put option allows the holder to sell MCshares for $40.00 when the current market price for MC is $35.00. Thisoption has a premium of $5.50, which consists of $5.00 of intrinsic valueand 50 cents time value. A put option is out-of-the-money when theshare price is above the exercise price, since a taker will not exercisethe put to sell the shares below the current share price.

As you may recall, put options convey the right, but not the obligationto sell the underlying shares. If the share price is above the exercise pricethen it is probably better to sell the shares on the share market and letthe option lapse.

It should be noted that when the share price equals the market price,the call and put options are said to be 'at-the-money'.

Time Value

Time value represents the amount that you are prepared to payfor the possibility that the market might move in your favorthroughout the life of the option. It represents and extra paymentto the writer of the option to offset the risk that the underlyingshare will move, and result in a loss to the writer. Time value willvary with in-the-money, at-the-money, and out-of-the-money optionsand is greatest for at-the-money options. As the time of expiry drawsnear and the opportunities for the option to become profitable decline,the time value decreases. This dilution of option value is termedtime decay. Time value does not decay at a constant rate,but becomes more rapid, possibly even exponential, as onegets closer to expiry.

Time value is influenced by the following factors, among others:time to expiry, interest rates, market volatility (which you can quantifyusing Bollinger Bands), dividend payments, and market expectations.

The time value of an option is greater the longer the time to expiry.The premium will be higher under conditions of high market volatility.Again, Bollinger Bands are a great way to measure market volatility.This is a consequence of the wider range over which the stock or commoditycan potentially move. As interest rates increase, call option premiums will be driven up,while put option premiums will be pushed down. Supply and demand will determine themarket value of all options. During times of strong demand, premiums will undoubtedlybe higher.

Hopefully this article will provide investors and traders considering purchasingor selling options with more information. Although technical analysis isuseful in attempting to predict market movement, fundamental analysis ofoptions via the use of the factors described above may provide many traderswith benefits as well.

Joshua M. Kunken is Chief Currency Analyst for ForeignMarketWatch.com.His articles have also been featured at ForexTrack.