Once you understand what options are, it’s time to learn about how they are priced.

That’s what we will cover in this option pricing guide for beginners.

Let’s first discuss the terms “In the Money”, “At the Money” and “Out of the Money”.

Then we will cover the two components that contribute to the price of an option:

- Intrinsic Value
- Extrinsic Value

### In the Money – At the Money – Out of the Money

ITM, ATM, OTM.

These terms significantly affect both intrinsic and extrinsic values, which form the basis of an option’s price. So we need to understand these first.

#### In the Money (ITM)

An option is considered ITM when exercising it immediately results in a profit.

**Call Option Example**: A Tesla call option with a strike price of $150 is ITM because buying Tesla stock at $150 (option’s strike price) when the market price is $170 allows for an immediate profit of $20 per share.**Put Option Example**: A Tesla put option with a strike price of $190 is ITM since you can sell Tesla stock at $190 (option’s strike price) versus the market price of $170, netting a $20 profit per share.

#### At the Money (ATM)

Options are ATM when the strike price and the stock’s current market price are equal or very close, meaning exercising the option doesn’t immediately result in a profit.

**Example**: A Tesla call or put option with a strike price of $170, when Tesla’s stock is also at $170, is considered ATM.

#### Out of the Money (OTM)

Options are OTM if exercising them immediately results in a loss due to the strike price being less favorable than the current market price.

**Call Option Example**: A Tesla call option with a strike price of $190 is OTM, as buying Tesla at $190 when the market price is $170 would result in a loss.**Put Option Example**: A Tesla put option with a strike price of $150 is OTM because selling Tesla at $150 when it trades at $170 is less advantageous.

### Intrinsic Value

Intrinsic value is only found in “ITM” options.

The intrinsic value of an option is the real, tangible value embedded within the option, based on its position relative to the stock’s current price. Here’s how it’s calculated for both call and put options that are ITM:

#### Intrinsic Value Formula

**Call Options**: Intrinsic Value = Current Stock Price – Strike Price**Put Options**: Intrinsic Value = Strike Price – Current Stock Price

#### Example

If Tesla is trading at $170 and you have:

- A call option with a strike price of $150, the intrinsic value is $20 ($170 – $150).
- A put option with a strike price of $190, the intrinsic value is $20 ($190 – $170).

The price of an option in the market is always at least the value of its intrinsic value when it’s “in the money.”

### Extrinsic Value

Beyond intrinsic value lies the concept of extrinsic value, or time value, which encompasses everything else that contributes to an option’s price. Extrinsic value is influenced by time until expiration, implied volatility, and the current market dynamics. It represents the premium that traders are willing to pay over the intrinsic value, based on their expectations of the stock’s future movement.

**Extrinsic Value**= Option Price – Intrinsic Value

In our example above with Tesla stock trading at $170. If you had a call option with the strike price of $150, the intrinsic value is $20 ($170 – $150). The call option’s market price is at least $20, reflecting its intrinsic value.

But if the option’s price is $25, then there’s $5 of extrinsic value. Perhaps the option does not expire for 30 days leaving more time for the stock price to rise. This extra $5 factors in things like time to expiration and the implied volatility of the stock.

Options with more time until expiration tend to have higher extrinsic value. This is because there’s a greater chance for the stock to make a significant move, potentially increasing the option’s value. For example, a Tesla call option with 60 days to expiration might be priced higher than one with 30 days, all else being equal.

### What is Implied Volatility?

Implied volatility is like the stock market’s best guess at how much a stock’s price might jump around in the future. This isn’t about whether the stock price will go up or down, but rather about how big those moves could be. This guess is not directly stated but is suggested by how much people are willing to pay for options right now.

Let’s simplify further:

- “Implied” can indeed be replaced with words like “suggested” or “hinted at.”
- “Volatility” is just how much a stock’s price changes over a certain period.

So, we could say that the suggested volatility of a stock is hinted at by the current prices of options for that stock. These options are contracts that let investors buy or sell the stock at a set price before a certain date. The price of these options goes up or down based on how much people think the stock itself will move.

In essence, the suggested volatility is a clue about the expected ups and downs in a stock’s price, as seen through the lens of options prices. This is a critical piece of the puzzle for investors and traders who use options to try to profit from or protect against these price movements.

#### Implied Volatility in Percentages

When a stock has an implied volatility (IV) of 50% or 15%, these percentages give you an idea of how much the stock is expected to move over the next year. Here’s a breakdown of what these numbers mean:

**Implied Volatility of 50%**: This suggests that the market expects the stock to be more volatile. In simpler terms, the market is predicting that the stock’s price could go up or down by 50% over the next year, based on the current prices of its options. This is a higher level of volatility, indicating that the stock’s price is expected to swing quite a bit. This could be due to upcoming news, earnings reports, or any number of factors that could affect the stock’s price.**Implied Volatility of 15%**: Conversely, an IV of 15% suggests that the market expects the stock to be less volatile. This means the market is predicting that the stock’s price could move up or down by 15% over the next year. This is a lower level of volatility, indicating that the stock’s price is expected to be more stable, with fewer dramatic swings.

It’s important to note that these percentages don’t predict the direction of the price movement (whether up or down); they only give an idea of the magnitude of the possible movement. Higher implied volatility often means higher option prices because there’s a greater potential for the stock to make a significant move, which could make the options more valuable. Conversely, lower implied volatility means lower option prices, as the expected movement of the stock is less dramatic.

#### I Asked ChatGPT: What Came First, the Chicken or the Egg?

The question of what comes first – options prices affecting implied volatility or market sentiment influencing options prices – is indeed similar to the chicken-and-egg scenario. In reality, it’s a continuous feedback loop:

**Market Sentiment Influencing Options Prices:**Initially, traders’ perceptions of future volatility, influenced by news, events, or economic indicators, drive the buying and selling of options. This market sentiment determines the premium (price) of options. For example, if traders believe a stock will be highly volatile, they might be willing to pay more for options to buy (call options) or sell (put options) the stock, driving up options prices.**Options Prices Affecting Implied Volatility:**The prices of these options are then used to calculate implied volatility. Higher options prices, suggesting higher expected volatility, result in higher implied volatility values. Conversely, lower options prices suggest lower expected volatility, leading to lower implied volatility values.**Feedback Loop:**The implied volatility, once calculated, provides a standardized measure of expected volatility that all market participants can see. Traders might adjust their positions based on these IV levels, buying options if they believe the IV is too low (expecting more volatility) or selling if they think the IV is too high (expecting less volatility). This adjustment in positions can then influence options prices again, continuing the cycle.

In essence, market sentiment and expectations initially shape options prices, which then define implied volatility. This implied volatility feeds back into the market, influencing future trading decisions and thus options prices again. The process is dynamic, with both elements constantly influencing each other.

### Summary: Key Influencers of an Option’s Price

#### Stock Price Movements

The daily fluctuations in the stock price directly affect an option’s intrinsic value. For “in the money” options, any change in the stock price alters the intrinsic value which changes the price of the option.

#### Time Decay

As an option nears its expiration, the extrinsic value erodes, a phenomenon known as time decay. This effect is more pronounced for short-term options, which are cheaper due to their limited time for potential stock movement.

#### Implied Volatility: The Market’s Expectation

Implied volatility reflects the market’s forecast of a stock’s potential price range over a specific period. It’s deduced from current option prices, indicating how much the stock might move, but not the direction. It plays a role in determining an option’s extrinsic value.