Chapter 4: What determines an option's price?
An option's price (called the premium) is not a random number set by the seller. It comes from a precise formula driven by six main market factors.
To understand pricing easily, remember that a contract's price has two parts:
- Intrinsic value: the direct, actual profit the contract has right now (if any).
- Time value: the extra amount traders pay in the hope the stock moves their way before expiration.
The six pricing factors and their effect
Here is how these variables affect the value of calls (Call) and puts (Put) when they rise:
| Factor (when it rises ↑) | Effect on a call | Effect on a put |
|---|---|---|
| Stock price ↑ | Rises ↑ | Falls ↓ |
| Strike price ↑ | Falls ↓ | Rises ↑ |
| Time to expiration ↑ | Rises ↑ | Rises ↑ |
| Implied volatility (IV) ↑ | Rises ↑ | Rises ↑ |
| Interest rates ↑ | Rises slightly | Falls slightly |
| Announced earnings and a nearby event ↑ | Falls (IV Crush) | Falls (IV Crush) |
❄️ Time decay (Theta): the buyer's enemy and the seller's friend
Options are instruments with a set lifespan and an expiry date. Every day that passes without the stock moving, the contract loses part of its time value.
A simple analogy: picture the option as a block of ice that keeps melting as time passes.
- If you are the buyer of the contract: you hold the block of ice, and time melts your gains every day (THETA works against you).
- If you are the seller of the contract: you want the block of ice to melt completely so you keep the premium (theta works in your favor).
Note: a contract's time decay speeds up sharply in the last 30 days before expiration.
💥 What is the volatility crush (IV Crush)?
Implied volatility (IV) measures how violent a move the market expects in the stock. Before big events such as quarterly earnings, implied volatility jumps sharply because investors don't know which way the stock will go (expensive insurance).
Once the earnings report is out and everyone knows the results, the uncertainty disappears and implied volatility drops fast, back to its normal range. This sharp drop is called IV Crush. It cuts the prices of CALL and PUT contracts at the same time, even if the stock moved a little in your favor.
Summary and what next?
You now understand how contract prices move and how time and volatility affect them. In the next and final chapter of this track, we move to practice: placing your first options trade step by step and setting the risk before you enter. The Greeks, which measure these changes in numbers, get a full chapter in the "Options income strategies" track.
