What Drives Option Prices? [2-Part Structure]

Key Concepts

• Intrinsic Value: The immediate worth of an option based on whether it is "in the money."
• Extrinsic Value: The portion of an option's price that is not intrinsic value, influenced by time, volatility, and the proximity effect.
• In the Money (ITM): An option whose strike price is favorable relative to the underlying asset's current price.
• At the Money (ATM): An option whose strike price is equal to the underlying asset's current price.
• Out of the Money (OTM): An option whose strike price is unfavorable relative to the underlying asset's current price.
• Time Value: A component of extrinsic value representing the potential for the option to become more profitable before expiration.
• Volatility: A measure of the expected price fluctuations of the underlying asset, influencing extrinsic value.
• Proximity Effect: The impact on extrinsic value based on how close an option's strike price is to the at-the-money strike.

Option Pricing Components

The price of an option is comprised of two fundamental components: intrinsic value and extrinsic value.

Intrinsic Value

Intrinsic value represents the immediate worth of an option to the long side of the contract, irrespective of whether it is a call or a put. It is determined by whether the option is "in the money."

• In the Money (ITM) Options: These options possess intrinsic value.
  • Example: A call option that is $6 in the money has an intrinsic value of $6.
  • Example: A put option that is $9 in the money has an intrinsic value of $9.
• At the Money (ATM) and Out of the Money (OTM) Options: These options have no intrinsic value.

Therefore, the first component of any option's price is its intrinsic value.

Extrinsic Value

Extrinsic value accounts for all factors influencing the option's price beyond its intrinsic value. The three primary drivers of extrinsic value are time, volatility, and the proximity effect.

• Time:
  • Principle: More time until expiration generally leads to higher extrinsic value.
  • Principle: Less time until expiration generally leads to lower extrinsic value.
• Volatility:
  • Principle: Higher expected volatility of the underlying asset generally leads to higher extrinsic value.
  • Principle: Lower expected volatility of the underlying asset generally leads to lower extrinsic value.
• Proximity Effect:
  • Definition: This effect is more complex but can be understood as the influence of how close an option's strike price is to the at-the-money strike.
  • Impact: The closer the strike price is to the at-the-money strike, the greater the proximity effect and, consequently, the higher the extrinsic value.
  • Application (OTM): An option that is only slightly out of the money will exhibit a stronger proximity effect and possess more extrinsic value compared to an option that is further out of the money.
  • Application (ITM): Similarly, an option that is only slightly in the money will have a stronger proximity effect and more extrinsic value than an option that is deeper in the money.

The proximity effect is a significant factor in determining the overall extrinsic value of an option.

Synthesis/Conclusion

The price of any option is a sum of its intrinsic value and extrinsic value. Intrinsic value is a direct measure of an option's current profitability (being "in the money"). Extrinsic value, on the other hand, captures the potential future value, driven by the remaining time to expiration, the expected volatility of the underlying asset, and the proximity of the strike price to the current market price of the underlying asset. Understanding these components and their drivers is crucial for comprehending option pricing.