Did you Know?
components of the option's price
As an introduction, we can say that the value of an option is a function of three elements:
These three elements are captured in the concept of intrinsic and extrinsic value.
An option's price depends on both the intrinsic and extrinsic value of the option.
The intrinsic value is the value of the option if it were exercised immediately for cash. It is function of the relationship between the market value of the underlying asset and the strike price of the option.
Intrinsic value of a call
underlying price minus strike price (minimum 0).
In theory, the intrinsic value of an option will always set the minimum price (premium) of the option. As an option is a right and not an obligation to do a transaction at a fixed price, the intrinsic value and the premium cannot be valued at less than 0.
The extrinsic value (called also time premium) is the value of he remaining time to expiration.
But how does the market set the price of the extrinsic value? This question will be studied in the 'pricing model' section.
The comparison between the strike price of the option and the market price of the underlying asset has introduced a specific terminology: in, at, and out of the money.
An option is said 'in the money' when the intrinsic value is greater than 0 (underlying price greater than strike price for a call and strike price greater than underlying price for a put).
An option is said 'at the money' when the strike price is equal to the underlying price.
An option is said 'out of the money' when the 'mathematical' intrinsic value is lower than 0 (underlying price greater than strike price for a put and strike price greater than underlying price for a call). We have used here the mathematical relation because, as we have said above, the intrinsic value cannot be lower than 0.
In the next section, we will see how we can calculate the price of an option.
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