Options Pricing: What Determines an Option’s Price
The Two Components of an Option’s Price
Intrinsic Value
Intrinsic value is the real, tangible value of an option — how much you’d gain if you exercised it right now. Only in-the-money options have intrinsic value.
| Option Type | Intrinsic Value Formula | Example (Stock at $210) |
|---|---|---|
| Call (Strike $200) | Stock Price – Strike Price | $210 – $200 = $10 |
| Put (Strike $220) | Strike Price – Stock Price | $220 – $210 = $10 |
| Call (Strike $220) | Max(Stock – Strike, 0) | $0 (out of the money) |
Time Value
Time value is the premium above intrinsic value. It reflects the probability that the option could become more valuable before expiration. Time value is highest for at-the-money options and decays as expiration approaches — this is theta decay.
An at-the-money call trading at $8 when the stock equals the strike has zero intrinsic value. The entire $8 is time value — a bet on future movement.
The Five Factors That Drive Options Pricing
| Factor | Effect on Call Price | Effect on Put Price | Why |
|---|---|---|---|
| Stock price increases | Increases ↑ | Decreases ↓ | Calls become more ITM; puts become more OTM |
| Higher strike price | Decreases ↓ | Increases ↑ | Higher strike = harder for call to be ITM |
| More time to expiration | Increases ↑ | Increases ↑ | More time = more chance of favorable move |
| Higher implied volatility | Increases ↑ | Increases ↑ | Greater expected movement benefits both types |
| Higher interest rates | Slight increase ↑ | Slight decrease ↓ | Carrying cost effect via cost of capital |
Implied Volatility: The Most Important Variable
Implied volatility (IV) is the market’s forecast of how much the stock will move over the option’s life. It’s expressed as an annualized percentage. High IV means the market expects big moves — and options get expensive. Low IV means calm expectations — and options are cheap.
IV is the one factor that can change dramatically without the stock price moving at all. Before earnings announcements, IV spikes because the market expects a big move. After earnings, IV collapses (called “IV crush”), and options can lose significant value even if the stock moves in your direction.
This is why understanding IV is critical for the Greeks, particularly vega.
The Black-Scholes Model
The Black-Scholes model is the foundational formula for pricing European-style options. Published in 1973, it provides a theoretical fair value based on five inputs: stock price, strike price, time to expiration, risk-free interest rate, and volatility.
Where S = stock price, K = strike price, T = time to expiration, r = risk-free rate, and N() is the cumulative normal distribution function. In practice, traders rarely calculate this by hand — pricing is built into every trading platform.
The model has limitations: it assumes constant volatility, no dividends, and European-style exercise. Real markets deviate from these assumptions, which is why actual option prices differ from Black-Scholes theoretical values.
How Time Decay Works
Time value erodes every day an option gets closer to expiration. This decay isn’t linear — it accelerates dramatically in the last 30 days. Theta measures this daily erosion.
| Days to Expiration | Relative Time Value | Daily Theta Impact |
|---|---|---|
| 90 days | High | Low (~$0.03/day) |
| 60 days | Moderate-High | Moderate (~$0.05/day) |
| 30 days | Moderate | Increasing (~$0.08/day) |
| 14 days | Low | High (~$0.12/day) |
| 7 days | Very Low | Very High (~$0.18/day) |
This is why option sellers prefer to sell with 30-45 days to expiration — they capture the steepest part of the time decay curve while maintaining reasonable premium.
Key Takeaways
- Option price = Intrinsic value + Time value. Only in-the-money options have intrinsic value.
- Five factors drive pricing: stock price, strike, time, implied volatility, and interest rates.
- Implied volatility is the most dynamic factor — it can spike before events and crash afterward (IV crush).
- Time decay accelerates as expiration approaches, especially in the final 30 days.
- The Black-Scholes model provides theoretical pricing, but real markets adjust for dividends, early exercise, and skew.
Frequently Asked Questions
Why are options more expensive before earnings?
Implied volatility spikes before earnings because the market expects a big move from the announcement. Higher IV directly increases both call and put prices. After earnings, IV collapses back to normal levels, often causing options to lose value even if the stock moves in the expected direction.
What is IV crush?
IV crush is the sharp drop in implied volatility after an anticipated event (earnings, FDA decisions, etc.) passes. Since higher IV means higher option prices, a sudden IV drop causes options to lose value rapidly. This is why buying options before earnings is risky — you need the stock to move more than the market expects just to break even.
How do I know if an option is overpriced?
Compare the current implied volatility to historical volatility. If IV is significantly higher than the stock’s actual movement over similar periods, options are relatively expensive. IV percentile ranks current IV against its past range — above 50% means options are more expensive than usual.
Does time decay happen on weekends?
Yes and no. Theta decay is a continuous mathematical process, but market prices only update during trading hours. In practice, weekend time decay is often priced into Friday’s closing prices and Monday’s opening prices. Some traders avoid holding short-duration options over weekends for this reason.
Why do deep out-of-the-money options still have value?
Even options far from the money have time value because there’s a nonzero probability the stock could reach that level before expiration. The further out the expiration, the more time value these options have. As expiration approaches with the stock nowhere near the strike, this value rapidly approaches zero.