The Fundamentals of Option Pricing
An option's price (premium) equals its intrinsic value plus its time value. Intrinsic value is what the option would be worth if exercised now: stock price minus strike for a call, strike minus stock price for a put, and zero if out of the money. Time value is everything above that, and it depends on time to expiration, implied volatility, interest rates and dividends. Pricing models such as Black-Scholes (for European-style options) and the binomial model (often used for American-style options) combine these six inputs (stock price, strike, time, volatility, rate and dividends) into a theoretical price.
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The six inputs to an option's price
- Stock price and strike: set the intrinsic value. Calls gain value as the stock rises; puts gain as it falls.
- Time to expiration: more time means more chance of a large move, so more time value.
- Implied volatility: the market's expected volatility of the stock over the option's life. Higher implied volatility raises the price of both calls and puts.
- Interest rates: higher rates slightly raise call prices and lower put prices.
- Dividends: expected dividends lower call prices and raise put prices.
Option pricing models
The Black-Scholes model gives a closed-form price for European-style options, which can only be exercised at expiration. The binomial model builds a tree of possible stock prices over time, which lets it handle American-style options that can be exercised early. Both depend heavily on the volatility input, which is why traders often work backward from market prices to find implied volatility.
Time value and time decay
Time value shrinks as expiration approaches and reaches zero at expiration, when an option is worth only its intrinsic value. This decay (theta) works against option buyers and in favor of option sellers, and it speeds up in the final weeks before expiration.
The Greeks
The Greeks measure how an option's price responds to each input: delta (stock price), gamma (the rate of change of delta), theta (time), vega (implied volatility) and rho (interest rates). Traders use them to understand and manage the risk of a position.
Analyzing option prices with MarketXLS
MarketXLS is an Excel add-in that returns option chains, quotes and Greeks through formulas such as =QM_GetOptionChain("AAPL") and =QM_GetOptionQuotesAndGreeks("AAPL"), so you can compare market prices, implied volatility and Greeks across strikes in a spreadsheet. Options data is end-of-day on the Standard plan and real-time on the Advanced and Business plans. This article is educational and not investment advice.
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Relevant blogs that you can read to learn more about the topic
How Are Options Priced?
Get RealTime Updated Option Prices
A Comprehensive Look at Option Symbols