Options Workshop 4: The Basics of Option Pricing
Option pricing isn’t magic — but it is more complex than pricing shares.
At its core, an option’s premium is driven by supply and demand. What buyers are willing to pay, and what sellers are willing to accept. That demand is shaped by expectations: where the share price might go, how long there is until expiry, and how risky the move could be.
To use options effectively, traders need to understand what actually moves premiums — and why.
3.1 The Main Drivers of Option Premiums
Several variables interact to determine the price of an option. Change one, and the premium changes — sometimes sharply.
The takeaway: option prices are forward-looking. They reflect what the market expects, not just where the stock is today.
3.2 Volatility: The Engine of Option Pricing
Volatility measures how much and how fast a share price moves. Formally, it’s the annualised standard deviation of daily returns — but practically, it’s a measure of uncertainty.
A volatile stock doesn’t need direction to make options expensive. It just needs movement.
This is why options often become expensive ahead of earnings, macro events, or policy decisions — even before the stock actually moves.
The Three Types of Volatility
Historical Volatility (HV)
What the stock has done in the past. Calculated from historical price data.
What the stock has done in the past. Calculated from historical price data.
Future (Expected) Volatility
An estimate of how much the stock might move over a future period. This can’t be observed directly, but it drives pricing decisions.
An estimate of how much the stock might move over a future period. This can’t be observed directly, but it drives pricing decisions.
Implied Volatility (IV)
Backed out from option prices themselves. IV reflects the market’s collective expectations and is the volatility traders watch most closely — especially around events.
Backed out from option prices themselves. IV reflects the market’s collective expectations and is the volatility traders watch most closely — especially around events.
3.3 What Makes Up an Option Premium?
Every option premium has two components:
1. Intrinsic Value
This is the “real” value of the option if it were exercised right now.
– Call option: Intrinsic value = Share price − Strike price
– Put option: Intrinsic value = Strike price − Share price
Only in-the-money (ITM) options have intrinsic value.
Example:
XYZ trades at $105.
A $100 call is priced at $8.
XYZ trades at $105.
A $100 call is priced at $8.
– Intrinsic value = $5
– Time value = $3
2. Extrinsic Value (Time Value)
Time value is everything above intrinsic value. It reflects uncertainty and opportunity.
It’s influenced by:
– Time remaining until expiry
– Expected volatility
– Interest rates
– Dividends
Out-of-the-money (OTM) options consist entirely of time value.
Time Decay: The Silent Enemy
Time is a wasting asset for option buyers. Every day that passes chips away at the option’s time value — even if the share price doesn’t move.
This erosion accelerates as expiry approaches.
Time Decay Timeline
60 Days to Expiry
– Time value is high
– Decay is slow
– Option holds value even if price is flat
30–15 Days to Expiry
– Decay accelerates
– Premium drops faster each day
– Buyers need a move soon
– Sellers benefit if the market stalls
7–0 Days to Expiry
– Time value collapses
– OTM options can expire worthless
– ITM options retain intrinsic value and are exercised automatically
This is why traders often say:
“Time is not your friend when you’re long options.”
Where Time Value Is Highest
Time value peaks when an option is at the money (ATM).
Why?
Because this is where uncertainty is greatest — the option could finish ITM or OTM with even a small move.
Because this is where uncertainty is greatest — the option could finish ITM or OTM with even a small move.
As options move further ITM or OTM, the probability of a dramatic change falls — and so does time value.
Quick Summary
– Option premiums fall faster as expiry approaches
– Time decay accelerates in the final weeks
– ATM options carry the most time value
– Buyers need movement — sellers need time to pass
Understanding these mechanics helps traders plan entry, exit, and risk — rather than guessing.
Summary Table: How Key Variables Affect Option Prices
Disclaimer: Moomoo Technologies Inc. is providing this content for information and educational use only.
Read more
Comment
Sign in to post a comment
71157471 : I don't fully understand how option works.
sarcasticlychalanged : hi5
75938506 : every time I think I have it, understand what i am doing, it slips away
MoMoneyMo : good explanation
75505850 71157471 : its gambling on your opinions
JRE : Well done. ty
Slay2dudes : ok
ddd dfs : thank you for number on each workshop, so that I can follow by order
poloberto :
103676609 :![[undefined]](https://static.moomoo.com/nnq/emoji/static/image/default/default-black.png?imageMogr2/thumbnail/36x36 "undefined")
View more comments...