How Options Are Priced - The Basics

Why This Concept Is Foundational to Options Trading

If you're new to options, chances are you've looked at a call or put on your broker's screen and wondered: "Why does this option cost $2.50?"

That's not just a passing curiosity.

Understanding how options are priced is one of the most important lessons you'll ever learn as a trader. Because when you truly understand what goes into that number, and how it moves, you stop trading blindly. You start trading with purpose.

Think of it this way: An option price isn't just a number. It's a reflection of time, volatility, value, and market expectations. It tells a story about the future, priced in dollars today.

In this deep-dive, you'll learn:

• The two components of every option price

• Why options lose value over time (and how you can use that to your advantage)

• How volatility affects premiums

• How to evaluate option pricing like a professional

Let’s take it from the top.

What Is an Option, Really?

An option is a financial contract that gives the buyer the right, but not the obligation, to buy or sell a specific stock (or ETF) at a predetermined price (called the strike price) before or at a certain date (called the expiration date).

There are two basic types of options, calls and puts:

• Call Options: Give the holder the right to buy the underlying asset.

• Put Options: Give the holder the right to sell the underlying asset.

The price a trader pays to buy an option is called the premium. This premium fluctuates based on several key factors. But at its core, every option premium is made up of two elements: intrinsic and extrinsic value.

Every Option Price Has Two Parts

Let’s say you see a call option trading for $4.00. That $4.00 isn't arbitrary. It's made up of:

1. Intrinsic Value: The Real, Right-Now Value

This is the portion of the option’s price that represents immediate value if the option were exercised today.

• Call Option Intrinsic Value: If the stock is trading above the strike price, the intrinsic value = Stock Price – Strike Price.

• Put Option Intrinsic Value: If the stock is trading below the strike price, the intrinsic value = Strike Price – Stock Price.

Example:

• Stock: $110

• Call Strike: $100

• Intrinsic Value = $110 - $100 = $10

• Stock: $90

• Put Strike: $100

• Intrinsic Value = $100 - $90 = $10

If an option is out-of-the-money (the strike price is unfavorable), it has no intrinsic value. That doesn't mean it has no premium, it means all of that premium is made up of extrinsic value.

2. Extrinsic Value: The Value of Time, Volatility, and Possibility

Extrinsic value is the portion of the premium that accounts for:

• Time left until expiration

• Expected volatility of the stock

• Interest rates and dividends (for longer-dated options)

Extrinsic value reflects possibility, not reality.

Even if an option has no intrinsic value, it can still cost money. That’s because of the potential it may have before expiration.

Example:

• Stock is $98

• Call strike is $100

• Option trades at $2.00

• Intrinsic value = $0 (since $98 < $100)

• Extrinsic value = $2.00 (entire premium)

⏱️ Time Decay: How Options Lose Value Daily

Options are wasting assets. As time passes, the window of opportunity for the option to move into the money gets smaller. This decay in value is measured by the Greek theta.

• Theta estimates how much an option will lose in value with the passage of one day, all else being equal.

• As expiration nears, time decay accelerates, especially in the final 30 days.

Think of extrinsic value like a melting ice cube. The closer to expiration, the faster it melts.

Time decay only affects extrinsic value.

• If an option has only intrinsic value (deep in-the-money, very near expiration), it’s less affected by theta.

Volatility: The Most Misunderstood Driver of Price

Another major driver of option pricing is implied volatility (IV).

• Implied Volatility represents the market’s expectation for how much the stock might move, up or down, over a given time frame.

• Higher IV = higher premiums

• Lower IV = lower premiums

Why? Because if a stock is expected to move more, there's a higher chance it could go deep in- or out-of-the-money. That uncertainty increases extrinsic value.

High IV doesn’t mean the stock will move. It means the market is expecting it to move.

Example:

• Before earnings, IV rises, making options more expensive.

• After earnings, IV often collapses (known as IV crush), causing option prices to drop, even if the stock moves.

Understanding IV helps traders avoid overpaying and allows them to strategically sell options when premiums are inflated.

A Practical Example: Breaking Down an Option Price

Let’s look at a different real-world example with updated pricing for clarity:

• Underlying Stock: AAPL

• Stock Price: $205.00

• Call Option Strike: $200

• Days Until Expiration: 30

• Option Premium: $11.00

Step-by-Step Breakdown:

• Intrinsic Value:

  • $205 (stock) - $200 (strike) = $5.00

• Extrinsic Value:

  • $11.00 (premium) - $5.00 (intrinsic) = $6.00

That $6.00 represents the cost of time, volatility, and all the uncertainty between now and expiration.

What happens if the stock stays at $205 until expiration?

• The call would still be worth $5.00 (intrinsic value).

• But since you paid $11.00, you’d lose $6.00.

• That $6.00 disappears due to time decay, assuming no change in IV.

This is time decay in action. Even when you're "right" about direction, being wrong on timing or volatility can result in a loss.

So What Moves Option Prices?

Understanding the balance of these forces is what separates speculation from strategy.

Optional: Black-Scholes and Option Pricing Models

Option pricing isn’t guesswork. Mathematicians use models to calculate theoretical values.

The most well-known is the Black-Scholes Model, which uses:

• Current stock price

• Strike price

• Time to expiration

• Risk-free interest rate

• Implied volatility

These models provide a "fair value" estimate, but actual option prices may differ slightly due to real-world factors like supply, demand, and bid-ask spreads.

✅ Takeaways for New Traders

To recap and reinforce:

• Always break down an option price into intrinsic + extrinsic value.

• Time decay is real and gets faster closer to expiration.

• Volatility inflates or deflates prices, pay attention to IV before trading.

• Understand what part of the premium you're paying for. Is it real value or just possibility?

• Avoid buying expensive options unless you believe the stock will move quickly and significantly.

"You don’t need to predict the future to trade well. You just need to understand what’s already priced in."

"Options mirror our beliefs, fears, and expectations. The smartest traders learn to read those reflections."

Final Thought: Options Are a Market of Expectations

Every price on your options chain is telling you something. It’s a probability. A forecast. A premium placed on potential.

If you can read those signals, you’re not just guessing anymore. You’re trading with purpose, understanding, and control.

That’s what separates the beginner from the strategist.

Want More Options 101 Lessons?

This article is part of our Options 101: First Steps to Trading series at The Option Premium, designed to build a rock-solid foundation for options traders.

👉 Subscribe to our free newsletter to get:

• Weekly educational articles

• Step-by-step trade breakdowns

• High-probability portfolio strategies

We’re here to help you trade smarter, with confidence, clarity, and consistency.

Probabilities over predictions,

Andy Crowder

🎯 Ready to Elevate Your Options Trading?
Subscribe to The Option Premium, a free weekly newsletter delivering:
✅ Actionable strategies.
✅ Step-by-step trade breakdowns.
✅ Market insights for all conditions (bullish, bearish, or neutral).

📩 Get smarter, more confident trading insights delivered to your inbox every week.

📺 Follow Me on YouTube:
🎥 Explore in-depth tutorials, trade setups, and exclusive content to sharpen your skills.