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Introduction to Derivatives

Options Pricing

How is the price of an option determined?

There are many factors that can impact the option price (also knows an the premium) and the profitability of an options contract. Below are three key components that determine the price of an option.

Intrinsic Value

If an option is **in the money** this means that the buyer would chose to exercise the option right now if they could as the option gives them better prices than the market. In this scenario it is said to have **intrinsic value**. To calculate how much of an option's premium is due to intrinsic value:

- For a call option: Current price - Strike price
- For a put option: Strike price - Current price

Intrinsic value plays a part in the pricing because if the option premium is primarily made up of intrinsic value. The remaining value of the option is based on movements in the underlying asset price (Volatility).

Implied Volatility

The rate at which a stock's price fluctuates, called volatility, also plays a role in the probability of an option expiring in the money. Implied volatility is the volatility that the market expects. This can inflate the option price if traders expect high volatility.

Time Value

The time remaining until an option's expiration has monetary value associated with it, which is known as time value. The more time that remains before the option's expiry the more possibilities there are for your desired outcome to occur, therefore more time value is embedded in the option's premium.

Last modified 8mo ago

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