A Part in Options Pricing: What Determine Option Premiums?

Time mean money, let me directly tell you what I am going to talk about: What determine option premiums? Learning about options pricing, such the basic knowledge is needed. Back to our answer, you know option premiums are determined the same way futures prices are done; through active competition between buyers and sellers. In other words, they are determined by basic supply and demand fundamentals.
There are two components determining option premiums: Intrinsic value and Time value. We have this:

Intrinsic value + Time value = Premium

In which

• Intrinsic value: is the amount of money that could be currently realized by exercising an option with a given strike price. An option’s intrinsic value will be determined by the relationship of the option strike price to the underlying futures price as below:

Puts: Strike price > Underlying futures price

Calls: Strike price < Underlying futures price

Here, a call option has intrinsic value if its strike price is below the futures price, and a put option has intrinsic value if its strike price is above the futures price. To sum up, an option has intrinsic value if it is currently profitable to exercise the option.

• Time Value: from the above formula, we have:

Total premium
- Intrinsic Value
= Time value

We can understand that if an option does not have intrinsic value, that option’s premium would be all time value. The mathematics of calculating time value shows that we can know time value when we know the total premium and the intrinsic value; however, it isn't easy to understand the factors that affect time value.

Actually, nothing is easy to learn about options pricing is not one-day job. There are plenty of things for us to research. If you also find it interesting and want to know more, Time Means Money will give you a hand.