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Concept
Valuation of options
Summary
In finance, a price (premium) is paid or received for purchasing or selling options. This article discusses the calculation of this premium in general. For further detail, see: for discussion of the mathematics; Financial engineering for the implementation; as well as generally.
This price can be split into two components: intrinsic value, and time value (also called "extrinsic value").
The intrinsic value is the difference between the underlying spot price and the strike price, to the extent that this is in favor of the option holder. For a call option, the option is in-the-money if the underlying spot price is higher than the strike price; then the intrinsic value is the underlying price minus the strike price. For a put option, the option is in-the-money if the strike price is higher than the underlying spot price; then the intrinsic value is the strike price minus the underlying spot price. Otherwise the intrinsic value is zero.
For example, when a DJI call (bullish/long) option is 18,000 and the underlying DJI Index is priced at 50 advantage even if the option were to expire today. This $50 is the intrinsic value of the option.
In summary, intrinsic value:call option
= current stock price − strike price (call option)
= strike price − current stock price (put option)
Option time value
The option premium is always greater than the intrinsic value up to the expiration event. This extra money is for the risk which the option writer/seller is undertaking. This is called the time value.
Time value is the amount the option trader is paying for a contract above its intrinsic value, with the belief that prior to expiration the contract value will increase because of a favourable change in the price of the underlying asset. The longer the length of time until the expiry of the contract, the greater the time value. So,
Time value = option premium − intrinsic value
There are many factors which affect option premium. These factors affect the premium of the option with varying intensity.
Official source
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