Section 4: Options Pricing Basics

You now know how to look at an options chain and identify different strike prices and expiration dates. But how is that "premium" price actually determined? Understanding this is like getting a peek behind the curtain – it empowers you to make smarter trading decisions.

Every option's price, or premium, is made up of two main parts: Intrinsic Value and Extrinsic Value.

Option Premium = Intrinsic Value + Extrinsic Value

Let's break down these components and the factors that influence them.

• Recall Moneyness (from Section 3.2):

  • In-the-Money (ITM) options are the only ones that have intrinsic value.

  • At-the-Money (ATM) and Out-of-the-Money (OTM) options have zero intrinsic value.

• Calculation for Calls (ITM):

  • Intrinsic Value = Current Underlying Stock Price - Call Option Strike Price

  • Example1: If Apple (AAPL) stock is at $185 and you have a Call Option with a $180 strike price, its intrinsic value is $185 - $180 = $5.00.

  • That means if you exercised the option now, you could buy AAPL at $180 and instantly sell it at $185, locking in a $5 profit per share.

  • Example 2 — Tesla (TSLA):
    If Tesla is trading at $200, and your call strike is $210, that option has no intrinsic value because $200 − $210 = −$10 → $0 intrinsic value (it’s OTM).

  • Example 3 — Real-Life Analogy:
    Imagine your friend gives you a coupon to buy an iPhone for $800, while the iPhone is selling for $1,000 in stores.
    That coupon immediately gives you a $200 advantage — that’s your intrinsic value.
    But if the iPhone is currently selling for $800, your coupon is worth nothing extra right now (OTM).

• Extrinsic value (also known as time value) is the portion of an option's premium that goes beyond its intrinsic value. It represents the market's expectation of how much the option could gain in value before it expires. It's basically the price you pay for the opportunity for the option to become more valuable.

  • Calculation:

    • Extrinsic Value = Total Option Premium - Intrinsic Value

  • What it represents: This value comes from the potential for the underlying stock's price to move favorably before expiration, and the uncertainty around that movement.

  • Key Idea: Even ATM and OTM options, which have no intrinsic value, still have extrinsic value. If an OTM call costs $2.00, that entire $2.00 is extrinsic value.

  • Example1: (continued from AAPL call): If AAPL stock is at $185 and its $180 strike Call Option has an intrinsic value of $5.00. If the total premium for that call option is currently $7.00, then its extrinsic value is $7.00 - $5.00 = $2.00. This $2.00 is the market's way of saying, "There's still potential for this option to become even more valuable, or for the stock to move more.

  • Example 2 — Netflix (NFLX) Call

    • Netflix trades at $500, and the $500 strike call is priced at $12.00.
      Because the strike and price are equal, it’s At-the-Money (ATM) → $0 intrinsic value.
      Therefore, all $12 is extrinsic value — the market is paying $12 purely for potential.

  • Example 3 — Tesla (TSLA) Put

    • Tesla trades at $200, and the $210 put costs $14.00.
      Intrinsic value = $210 − $200 = $10.00
      Extrinsic value = $14 − $10 = $4.00

    • That $4 shows traders believe Tesla might fall even further before expiration — they’re paying for that uncertainty.

  • Example 4 — Real-Life Analogy: Buying Insurance Early

    • Buying an option is a lot like buying insurance

    • If you insure your car for one full year, it costs more than a policy that expires next week — that’s extrinsic value (more time = more uncertainty).

    • Even if you haven’t had an accident yet, you still pay for the possibility of one happening — just like traders pay for the potential of price movement.

  • Example 5 — Plane Ticket Analogy

    • Imagine booking a plane ticket:

    • The face value (base cost) = intrinsic value

    • The price difference between now and last-minute = extrinsic value

    • If the flight is next month, you might pay $400. But if it’s tomorrow, the ticket could cost $700 because the chance of selling that seat is lower — this “time-related” price difference is extrinsic value at work.

    Key Idea:

    • Even ATM and OTM options — which have no intrinsic value — still have extrinsic value, because the stock might move in their favor before expiration.

    • Example:
      If an OTM call costs $2.00, the entire $2.00 is extrinsic value — you’re paying purely for potential.

      Quick Summary:

1. Intrinsic Value: The "In-the-Money" Part

Intrinsic value is the immediate profit an option would have if you exercised it right now. It's the "real" value based on the underlying stock's price relative to the option's strike price.

2. Extrinsic Value (Time Value): The "Potential" Part

• Calculation for Puts (ITM):

  • Intrinsic Value = Put Option Strike Price - Current Underlying Stock Price

  • Example 1 — Tesla (TSLA):
    If Tesla’s stock is $170, and you own a Put Option with a $175 strike, then:
    $175 − $170 = $5.00 intrinsic value.
    You could sell your stock for $175 (higher than the market price of $170), locking in a $5 profit.

  • Example 2 — Microsoft (MSFT):
    If MSFT trades at $350, and your put strike is $340, that’s $0 intrinsic value (OTM), because it wouldn’t make sense to sell at $340 when the market will pay you $350.

  • Example 3 — Real-Life Analogy:
    Think of it like having insurance on your car that guarantees you can sell it for $20,000, even if the market value drops to $18,000.
    That $2,000 difference is your intrinsic value — real money you could gain right now.

• Final Takeaway:

• Intrinsic value is what your option is already worth today.
  Extrinsic value is what you’re hoping it could be worth tomorrow.

• Both together make up the option premium, and understanding the split helps you see what part of your option’s price is real and what part is expectation.