There are two main concepts which relate to stock options pricing, intrinsic value pricing and premium value pricing. The price of an options contract which is sometimes referred to as an option premium consists of these two different components, intrinsic and premium value.

 

Intrinsic Value Pricing

 

Intrinsic value pricing is based on the value which is already built directly into the stock option the moment that it is purchased by a buyer. For example, if a stock is currently trading at $25, a call option for $10 will already have a $15 value built directly into it, allowing you to buy a $25 stock for only $10 dollars. Therefore, the option will be priced at $15 dollars plus a premium value. If the same stock is trading at $25, a put option with a price of $35 will have a $10 value built into it already, allowing you to sell that same stock for $60 the moment that you purchased it. The option will be priced at $10 plus a premium value. This option contract with intrinsic value built directly into it is known as an ITM or In the Money option.

 

Obtaining the intrinsic value for a call option has to do with subtracting the prevailing market price from the strike price of the underlying financial instrument based on the call option. So for example, if GOOG is trading for $300 per share, and a April$250Call option is requesting $52.00, then in the intrinsic value for the option would be $50, which is $350 minus $300. Obtaining the intrinsic value for a put option on the other hand it obtained by subtracting the strike price for the put option from the prevailing market price for the underlying financial instrument. So if GOOG is trading for $300 and the April$350Put option is asking for $51, the intrinsic value would be $50 which is $350 subtracted from $400.

 

Premium Value Pricing

 

At this point, you may be wondering what premium value is. The premium value, which is also sometimes called Time Value or even Extrinsic Value, is the part of an option's price which is determined using factors in addition to the price of the underlying financial instrument. This is the amount that you are paying to the seller of the option to cover the risk that he or she is taking by selling the option contract to you. This is 'risk money' that is being paid determinant upon four factors: The time to expiration, the interest rate, the volatility and the dividends payable. In order to accurately calculate the premium value amount for a stock option, a pricing model like the Black-Scholes Model is necessary. A stock option's price is based upon its premium value only when there is not already a built in value when the stock option is purchased meaning that it has no intrinsic value.

 

The price for an option is contract is also commonly called the option premium, but this term is misleading despite being so popular.

 

Premium Value, which is often referred to as Extrinsic Value or Time Value is part of an option's price which is determined using factors other than the underlying stock's price. This amount is what you are paying directly to the option's seller as a way to offset the risk that this seller is undertaking by selling the option contract to you. This money, which is essentially risk money, is paid to the seller based on four main factors which are used to justify it. These four factors include the time to expiration, the volatility, the dividends payable and the interest rates. If you have a Black-Scholes model, you may be able to calculate the premium value accurately for a stock option.

 

Pricing a stock option only involves its premium value if there is not already a built in intrinsic value when you purchased the aforementioned stock option. For example, if a stock currently trades at $50 dollars, a call option with a $60 stock price will not have an intrinsic value built into it already. A put option on the same stock with a strike price of only $40 will also have no intrinsic value built into it. Option contracts with no intrinsic value built into them are known as OTM options, or Out of the Money options.

 

Premium value for a call option can be obtained by subtracting the call price's option from its intrinsic value. So if GOOG is trading for $350, and the $300 call option is requesting $52 dollars, the intrinsic value is $50 and the premium value is $2, which is $52 - $50. The premium value for a put option on the other hand can be found by subtracting the put option's price by its intrinsic value. If GOOG is trading at $350 and the $400 Put Option is requesting $51.80, then the intrinsic value is $50 and the Premium Value is $1.80 which is $51.80 minus $50.

 

The premium value disappears from a stock option when that stock option contract has expired. So if you have purchased an OTM or Out-Of-The-Money call option, and the underlying stock's price never rises above the strike price, then the contract consisting only of the Premium Value will decay to zero, and all of your money will be lost.

 

Option premium is generally priced using the Black-Scholes model, which combines the amount of time remaining until the expiration date with the strike price, the prevailing interest rate, the underlying stock's current price, and an estimate for the future volatility which is called the IV or implied volatility, in order to generate a price which is theoretical in nature.