Options Pricing

A complete guide to options contract pricing, intrinsic and extrinsic value, the
Black-Scholes model, and more.
View risk disclosures

An option’s price, or value, is determined by the price of the option’s

underlying asset and the terms of the options contract. The price of an options
contract is also called the option premium.

The underlying security's price, the option's strike price, the time remaining
until expiration, the the underlying security's volatility, the current risk-free
interest rate, and the dividend rate of the underlying security are all
considered in determining an option contract's price.

Intrinsic value
The intrinsic value of an options contract is the value of the option at expiration.
If the contract expired immediately, the intrinsic value would be the only value
remaining on the contract.

To calculate the intrinsic value, take the difference between the current price
of the underlying security and the option contract’s strike price. The underlying
security’s current price, above or below the option contract’s strike price, is the
amount the contract is in-the-money.

A call option contract’s intrinsic value is the amount the underlying’s current
price is above the strike price.

For example, if stock XYZ is trading at $55 per share, a call option with a $50
strike price would be in-the-money and have an intrinsic value of $5. If the
underlying security’s price is below the call option’s strike price, the call option
is out-of-the-money and the intrinsic value would be $0.

Likewise, the intrinsic value of a put option contract is the amount the
underlying’s current price is below the strike price.

For example, if stock XYZ is trading at $45 per share, a put option with a $50
strike price would be in-the-money and have an intrinsic value of $5. If the
underlying security’s price is above the put option’s strike price, the put option
is out-of-the-money and the intrinsic value would be $0.
In most cases, the options contract’s value will exceed the intrinsic value
because of external factors like time until expiration and volatility. The excess
value beyond the intrinsic value is referred to as extrinsic value.

Intrinsic value is dependent on the strike price of the options contract. All else
being equal, as the strike price increases, the value of a call option decreases,
and the value of a put option increases. In this example, as the strike price
increases, the put option’s value increases because the underlying security
can be put to an option seller at a higher price.

Moneyness

Moneyness is used to describe the amount of intrinsic value for an options

contract. Moneyness is described in three categories: in-the-money, at-the-
money, and out-of-the-money. The degree of moneyness can change over the
life of an options contract.

In-the-money (ITM)

In-the-money options contracts are contracts with positive intrinsic value. For
example, a call option is in-the-money if the underlying security’s price is
higher than the option contract’s strike price.

A call option with a $50 strike price is in-the-money if the underlying security’s
current price is above $50.

At-the-money (ATM)

At-the-money options contracts are contracts where the option’s strike price is
equal to the underlying’s current price. A call option with a $50 strike price is
at-the-money if the underlying security’s current price is $50.

At-the-money options contracts have the greatest extrinsic or time value

because of the potential for changes in intrinsic value.

Out-of-the-money (OTM)

Out-of-the-money options contracts have no intrinsic value because the

contracts are “out-of-the-money” to be exercised based on the current
underlying security’s price and the contract’s strike price. For an out-of-the-
money call option, the underlying price is less than the option’s strike price.
Exercising an out-of-the-money options contract does not result in a positive
payoff. A call option with a $50 strike price is out-of-the-money if the
underlying security’s current price is below $50.

Deep-in-the-money (DITM)

Deep-in-the-money options contracts have a strike price significantly in-the-

money. For a call option, the options contract’s strike price would need to be
significantly below the current price of the underlying security. For a put
option, the strike price would need to be significantly above the current price
of the underlying security.

Generally, options contracts that are more than $10 in-the-money are
considered deep-in-the-money. Deep-in-the-money options have significant
intrinsic value and the other components of options pricing--such as time,
volatility, etc.--have less of an impact on the option’s value.

Deep-out-of-the-money (DOTM)

Deep-out-of-the-money options contracts have a strike price significantly out-

of-the-money. Because out-of-the-money contracts have no intrinsic value,
the value of deep-out-of-the-money options contracts comes from time,
volatility, and other options pricing components.

For deep out-of-the-money options contracts to have value at expiration, the

underlying security’s price will have to approach and then exceed the options
contract’s strike price. Therefore, the value of a deep-out-of-the-money
contract is dependent on a relatively large move in the underlying security.

Extrinsic value
Extrinsic value is the value of an options contract beyond its intrinsic value. The
extrinsic value of an options contract is also called the time value because the
remaining value is dependent on external factors such as the time remaining
on the contract, the volatility of the underlying security, the current risk-free
interest rate, and the dividend rate of the underlying security.

If the price of the underlying security is far above or far below the contract’s
strike price, then the extrinsic value factors have little influence on the option’s
price.
Extrinsic value is greatest when an options contract is at-the-money. Extrinsic
value decreases as options contracts get deeper in-the-money or deeper out-
of-the-money or closer to expiration.

Extrinsic value can be viewed as the true cost of an options contract because
the extrinsic value represents the cost of the opportunity to benefit from future
price movements of the underlying security.

Time value

Time value is the difference between the options contract’s price and the
intrinsic value of the option. As the time remaining until expiration decreases,
the time value of the options contract also decreases. The longer the time until
the options contract expires, the greater the opportunity for the underlying
security’s price to move and increase its intrinsic value.

Before expiration, the time value of an option is at least 0 and is almost

always positive.

Time value decay refers to the decline in the value of an options contract as it
approaches expiration. Time decay is non-linear, meaning the rate of change
increases as the options contract approaches expiration.

The rate of time decay for an options contract is called theta. Time decay, theta
burn, and theta decay are synonymous.
The image above illustrates how the time value of an options contract
decreases at an accelerating rate as expiration approaches. Time decay
increases more rapidly from 60 to 30 days than from 90 to 60 days, for
example.
While an option’s time value decreases as expiration approaches, other
extrinsic factors, such as Gamma and Vega, may increase as expiration
approaches, offsetting or exceeding Theta decay.

Volatility

Volatility in options contracts refers to the fluctuation in the price of the

underlying security. Volatility represents the likelihood of the underlying
security moves up or down. Securities with stable prices have low volatility,
while securities with large and frequent price movements have high volatility.

Volatility is an important determinant of an option’s price. Intrinsic value, the

time remaining until expiration, and the volatility of the underlying security are
the three primary factors contributing to an option’s price. The greater the
volatility of the underlying security, the higher the premium of the options
contract.

With increased price volatility, the range of possible payoffs is larger for the
options contract. Higher implied volatility indicates a higher expectation for
change in the options contract’s price value. The volatility of an options
contract is called Sigma.

Historical volatility

Historical volatility, or statistical volatility, is backward-looking and describes the

price movement of an underlying security in the past. Historical volatility is
typically presented for a specified range, such as the previous 20 days or over
the past year.

When presented graphically, historical volatility, whether increasing or

decreasing, displays the level of uncertainty in price movements for the
underlying security. While the standard “past performance is not indicative of
future returns” holds true, historical volatility gives context to the security’s
implied volatility.

Implied volatility

Implied volatility is forward-looking and represents the amount of volatility

expected in the future.

When calculated, implied volatility represents the expected one standard

deviation move for a security.
Implied volatility increases with large price movements in the underlying
security. As implied volatility rises, an options contract’s price increases
because the expected price range of the underlying security increases.
Implied volatility tends to increase, known as implied volatility expansion,
before events such as earnings releases or important Federal
Reserve announcements because these types of events bring uncertainty to
the market. Implied volatility decreases after the event--known as implied
volatility contraction--when the uncertainty is removed.

Implied volatility tends to be overstated relative to actual or historical volatility.

Option sellers look to capitalize on the over expectation of implied volatility.
IV rank

Implied volatility (IV) rank calculates where current implied volatility is

compared to values over the past year. Implied volatility is an absolute value,
so IV rank puts that absolute value into context by stating the current IV
compared to the one year high and low.

For example, if a security had implied volatility between 20 and 40 over the
past year and the current reading is 30, then the IV rank for the security would
be 50 because IV is at the midpoint of the past year’s range.
IV percentile

Implied volatility (IV) percentile represents the current implied volatility relative
to past values. IV percentile is similar to IV rank, but IV percentile describes
the percentage of days over the past year that implied volatility was below the
current level.

For example, an IV percentile of 90 means that implied volatility was below

the current level 90% of the time the past year.
Volatility smile & smirks

Volatility smile refers to the graphical representation plotting implied volatility

and an option’s strike price. Implied volatility increases as the strike price is
further out-of-the-money or further in-the-money compared to at-the-money.

Because of this increase on either side of at-the-money, the graph of implied

volatility and strike price resembles a smile. The graph shows options
contracts furthest away from the money have the highest implied volatility.
Volatility smirk refers to the volatility skew that commonly occurs in options
pricing where in-the-money calls and out-of-the-money puts are relatively
more expensive compared to out-of-the-money calls and in-the-money puts.

Higher volatility expectations are priced into downside protection, such as

deep out-of-the-money put options, than upside protection, such as deep out-
of-the-money call options, so the downside protection is “overpriced,”
relatively speaking.

Volatility smirks occur because investors are generally more concerned with
market crashes than market rallies. Securities tend to rise slowly or float
higher during rallies and drop rapidly during crashes. The value of downside
protection during periods of market volatility is greater and creates skew in
options pricing.

For example, think of purchasing home insurance in an area prone to

hurricanes. The risk is greater; therefore premiums will rise as potentially
harmful events become more likely.

Volatility smirks are also impacted by what is known as a synthetic collar

strategy, where investors purchase put options for downside protection and sell
call options to finance the purchase of the put options. This creates a higher
demand for the put options while lowering the price of the call options.

Volatility index (VIX)

The Cboe Volatility Index, or the VIX, was designed by the Chicago Board
Options Exchange to measure the 30-day expected volatility of the U.S. stock
market. The index is calculated using real-time price quotes on S&P 500
Index SPX call and put options. VIX futures and VIX options contracts provide
investors with liquid exposure to various volatility trading strategies and risk
management approaches.

The VIX is an important indicator of fear and volatility in the market and tends
to be mean-reverting. As more fear and uncertainty enters the market, the VIX
increases. Periods of high volatility are typically followed by periods of relative
calm as the uncertainty is removed from markets. Therefore, large spikes in
the VIX tend to be followed by declines as volatility expectations decrease.

Dividends

Dividends have a relatively minor effect on options prices. However, dividends

do impact options pricing because of the price movement of the underlying
security as a result of the dividend payment. Security prices are expected to
drop by the value of the dividend amount on the ex-dividend date, so high
dividend amounts impact options prices more than low dividends.

Dividend payments tend to lower call option premiums and increase put option
premiums. If the underlying security does not pay a dividend, then dividends
do not impact the price of options for that security.

Call option sellers should pay particular attention to dividends because if the
call option is in-the-money and the dividend amount exceeds the remaining
time value of the option, they are at greater risk of early assignment because
the option holder (buyer) can exercise his or her right and receive the dividend
payment.

Interest rates

Interest rates have a relatively minor impact on short-term options prices. A

90-day Treasury bill’s current interest rate is used to measure the risk-free
rate for many options pricing mathematical models. As interest rates rise, call
options prices increase while put options prices decrease.

Interest rates impact the value of security prices through models such as the
Capital Asset Pricing Model (CAPM) and therefore impact the value of options
contracts at different strike prices. Longer-dated options, or LEAPS, may be
affected because interest rates may change over the options contract’s
duration. The impact of interest rates on options contracts is called Rho.

Black-Scholes Model
The Black-Scholes Option Pricing Model is a mathematical model for pricing
options contracts created by Fisher Black and Myron Scholes. The Black-
Scholes Model is also referred to as the Black-Scholes-Merton model for
Robert Merton’s contribution to the work. For their work in options pricing
theory, Scholes and Merton received the 1997 Nobel Prize in Economics.

The Black-Scholes Model has five inputs: the current stock price, the option
strike price, the risk-free interest rate, the time remaining until expiration, and
the underlying security’s volatility. The model assumes a European-style
expiration, efficient markets, no dividends, no transaction costs, stable
volatility, constant risk-free rate, and the underlying security’s returns are
normally distributed. Developments discovered since the model’s creation,
such as volatility skew, have introduced additional limitations. Still, the Black-
Scholes model revolutionized the options industry and is still widely used
today.
Binomial pricing model
The binomial options pricing model uses an iterative, decision-tree approach
to determine an options contract’s value. One-period, two-period, and multi-
period binomial option pricing models can be used to calculate the value of an
options contract across different underlying security prices. The binomial
approach is also used in risk management applications for portfolio allocation
decisions by determining the appropriate number of call options, put options,
and long stock positions under various price scenarios.

Unlike the Black-Scholes Option Pricing Model, binomial pricing models can
be used for American-style options contracts and provide insight into whether
or not an options contract should be exercised early. Compared to the Black-
Scholes Option Pricing Model, many find binomial pricing models more
intuitive and are, therefore, more frequently used when pricing options. As
more periods are added to the binomial option pricing model, the option price
calculated using the binomial model converges on the calculated price of the
Black-Scholes model.

Monte Carlo simulation

Monte Carlo simulations estimate solutions or expected outcomes for complex
problems by running multiple iterations, or simulations, of variables across
expected ranges. Thousands of simulations are run to create a confidence
interval, or probability, that the expected outcome lies within a certain range.

Monte Carlo simulations generate random numbers from probability

distributions for each variable considered to make reasonable approximations
for problems and potential scenarios. Potential distributions include standard-
normal, triangular, log-normal, or poisson, along with many others. Monte
Carlo simulations are also called multiple probability simulations.

Monte Carlo simulations have multiple finance applications because many

independent variables have to be considered simultaneously when investing,
such as retirement planning, portfolio construction, risk management, and
numerous other areas. This simulation method was originally developed by
Stanislaw Ulam and John Von Neumann in 1946 as a method to estimate
probabilities in solitaire.
Bjerksund-Stensland model
The Bjerksund‐Stensland Model is a closed-form options pricing model used
to value American-style options contracts. The Bjerksund‐Stensland Model is
used to estimate the best time to exercise an options contract.

The Bjerksund‐Stensland Model approximates the value of options contracts

quicker and more efficiently than other pricing models and is frequently used
in brokerage platforms to calculate prices.

Options Greeks
Option Greeks are used to represent the variables that determine an option’s
constantly changing price. "The Greeks" reflect how outside factors will impact
an option’s value as certain conditions change.

Options prices do not always move equivalently to the underlying asset’s

price, and the Greeks help explain why. Greeks do not directly influence
options pricing and will not indicate where an asset’s price will trade in the
future. Instead, the Greeks are a way to measure an option's sensitivity to
ever-changing external factors. Their values are dynamic and will fluctuate as
price and information changes.

On most platforms, the Greeks are listed on the options chain along with the
bid/ask price, volume, and open interest.

There are many elements to an option’s price. Time until expiration, implied
volatility, changes in the underlying asset’s price, and interest rates all impact
the value of an option. There are five main Greeks, and each relates to either
the option’s intrinsic or extrinsic value.

Delta and gamma are dependent on the option’s spot and strike price and are
therefore derived from intrinsic value. Theta, vega, and rho are determined by
time to maturity, volatility, and interest rates, all of which are components of
extrinsic value.
Delta
Delta is the amount an options price should change based on a $1 move up in
the stock.

Call options have a positive delta between 0 and 1, while puts have a negative
delta between 0 and -1.

Delta would represent the number of relative shares you would own if you
purchased an option at a specific delta. Buying a call option with a .50 delta is
roughly equivalent to owning 50 shares of stock (and vice versa with put
options: -.50 delta is the same as shorting 50 shares).

For example, a stock priced at $100 has a $110 call option expiring in 60 days
with a delta of .30 and costs $2.00. If the underlying stock moves up to $101,
the option should now be worth $2.30. Owning 100 shares of the stock would
have realized a gain of $100. The .30 delta option realized approximately 30
shares worth of value, or $30.

Delta can also act as an approximation of the probability an option will finish
in-the-money. A .30 delta has roughly a 30% chance of expiring in-the-money
(or a 70% chance of expiring out-of-the-money).

Gamma

Gamma is closely related to delta. Gamma is the rate of change in delta for
every $1 change in the underlying price. Gamma represents the acceleration
at which an option's price increases or decreases. Think of gamma as the
next dollar move. ‍

For example, if an option has a delta of .40 and a gamma of .20, the first
dollar move in the underlying asset will see the price of the option change by
$0.40 ($40). The subsequent dollar move of the stock will see the price of the
option change another $0.40 ($40) plus an additional $0.20 ($20).

Therefore, a $2 move in stock price will result in a total net change of $1.00
($100) in the option’s price.

Gamma is higher for contracts closer to at-the-money and more sensitive to

changes in the underlying asset price.

Gamma risk is the concern that price changes in the underlying asset will have
an adverse impact on the option premium. Gamma risk increases as options
approach expiration because a small move in the underlying security will
significantly impact pricing due to the lack of time remaining on the contract.

Theta

Theta represents the effect time decay has on the value of an option. Options
are a decaying asset. Options contracts lose value daily from the passage of
time. The rate at which options contracts lose value increases exponentially
as options approach expiration. Theta is the amount the price of the option will
decrease each day.

For example, a theta value of -.02 means the option will lose $0.02 ($2) per
day.

Theta is always represented in negative terms because the portion of an

option’s value related to time is always going down. Theta value is smaller
further away from expiration and is not constant -- it accelerates more rapidly
the closer it gets to expiration.

Theta is an advantage for the option seller and a disadvantage for the
option buyer.

Vega

Vega is the amount option prices change for every 1% change in implied
volatility in the underlying security. Vega represents an unknown element
because future volatility cannot be predicted. All other components of an
option’s price can be determined objectively: spot price, strike price, and time
to expiration.

Vega has no impact on the intrinsic value of an option. It is not based on price
movement in the stock, only changes in volatility.

As volatility increases, an option’s price increases as market participants

anticipate an above-average move may be possible before expiration. Vega
decreases as it approaches expiration because there is less time for volatility
to occur.

Rho

Rho measures the sensitivity of an option’s price as it relates to changes in

interest rates. Rho represents the expected change of a contract’s value for a
1% change in interest rates. Rho is not as important for short-term options
traders because changes in interest rates are usually relatively small, and only
adjusted once per quarter, if at all.

Long-term options, or LEAPS, are more significantly impacted by changes in

interest rates because of their long expiration period. Investors hedging long-
term positions with options may also consider rho, as changes in interest rates
will affect the value of those positions.

Related articles
Intrinsic Value

Extrinsic Value

Options Moneyness (ITM, OTM, & ATM): The Complete Guide

Implied Volatility Options

Black-Scholes Model

Options Greeks

Delta Options

Theta Options

Vega Options

Gamma Options

Rho Options

Everything You Need to Know About IV Crush

Stock Options: 7 Factors that Determine Pricing and Value

Options Time Decay Explained: Understanding Theta

What is a Gamma Squeeze?

Historical Volatility

Skew

Volatility Smile

Volatility Smirk

Put-Call Parity

Bull Put Spread Profit Calculation

Bull Put Spread Risk Calculation

Bull Put Spread Break-Even Price

Bear Call Spread Profit Calculation

Bear Call Spread Risk Calculation

Bear Call Spread Break-Even Price

Iron Condor Profit Calculation

Iron Condor Risk Calculation

Iron Condor Break-Even Prices

FAQs
Is option price the same as option premium?

Yes, an option’s premium is the price of the option in the market. The
premium will be the cost to purchase or sell an option.
What is the difference between the Black-Scholes and binomial pricing models?

The Black-Scholes Model has five inputs: the current stock price, the
options strike price, the risk-free interest rate, the time remaining until expiration,
and the underlying security’s implied volatility. The model assumes a European-
style expiration, efficient markets, no dividends, no transaction costs, stable
volatility, constant risk-free rate, and the underlying security’s returns
are normally distributed.

The binomial options pricing model uses an iterative, decision-tree approach

to determine an options contract’s value. One-period, two-period, and multi-
period binomial option pricing models are used to calculate the value of an
options contract across various underlying security prices.

Unlike the Black-Scholes Option Pricing Model, binomial pricing models can
be used for American-style options contracts and provide insight into whether
or not to exercise an options contract early. Compared to the Black-Scholes
Option Pricing Model, many find binomial pricing models more intuitive and
are therefore more frequently used than the Black-Scholes model.

Does the Black-Scholes model work?

The Black-Scholes Model was groundbreaking when introduced, and the

authors won the Nobel Prize in economics in 1997. It is still widely used in the
industry to price options. However, there are some limitations to the model.
The Black-Scholes model only assumes European-style expiration, although
most options traded use American-style expirations. The model is also heavily
dependent on efficient markets and normal distribution. Detractors of the
model will argue markets are not efficient and do not have normalized
distributions.

Why is the Black-Scholes model important?

The Black-Scholes Model is important because it is a standardized formula that

allows all investors to calculate and assess an option contract’s value.

How do you use the Black-Scholes formula?

The Black-Scholes Model is used to calculate an option's value. The formula has
five inputs: the current stock price, the options strike price, the risk-free interest
rate, the time remaining until expiration, and the underlying security’s implied
volatility. The model assumes a European-style expiration, efficient markets,
no dividends, no transaction costs, stable volatility, constant risk-free rate, and
the underlying security’s returns are normally distributed.

Is Black-Scholes risk-neutral?

The Black-Scholes model is risk-neutral because one of its components is a

risk-free interest rate, as opposed to the underlying security’s implied risk or
expected return.

What is the risk-free rate for Black-Scholes?

Treasury bills typically represent the risk-free rate of return. The Black-
Scholes model uses the one-year Treasury bill for the risk-free rate.

How to calculate the Black-Scholes model?

The Black-Scholes Model has five inputs: the current stock price, the options
strike price, the risk-free interest rate, the time remaining until expiration, and
the underlying security’s volatility.