1. Options Pricing: Introduction
  2. Options Pricing: A Review Of Basic Terms
  3. Options Pricing: The Basics Of Pricing
  4. Options Pricing: Intrinsic Value And Time Value
  5. Options Pricing: Factors That Influence Option Price
  6. Options Pricing: Distinguishing Between Option Premiums And Theoretical Value
  7. Options Pricing: Modeling
  8. Options Pricing: Black-Scholes Model
  9. Options Pricing: Cox-Rubenstein Binomial Option Pricing Model
  10. Options Pricing: Put/Call Parity
  11. Options Pricing: Profit And Loss Diagrams
  12. Options Pricing: The Greeks
  13. Options Pricing: Conclusion

The price, or cost, of an option is an amount of money known as the premium. The buyer pays this premium to the seller in exchange for the right granted by the option. For example, a buyer might pay a seller for the right to purchase 100 shares of stock XYZ at a strike price of $60 on or before December 22. If the position becomes profitable, the buyer will decide to exercise the option; if it does not become profitable, the buyer will let the option expire worthless. The buyer pays the premium so that he or she has the "option" or the choice to exercise or allow the option to expire worthless.

Premiums are priced per share. For example, the premium on an IBM option with a strike price of $205 might be quoted as $5.50, as shown in Figure 1. Since equity option contracts are based on 100 stock shares, this particular contract would cost the buyer $5.50 X 100, or $550 dollars. The buyer pays the premium whether or not the option is exercised and the premium is non-refundable. The seller gets to keep the premium whether or not the option is exercised.

Option chain showing the various premiums and strike prices.
Figure 1 This option chain for the October 2012 IBM contract shows the various premiums and strike prices. Chart created at CBOE.com.

An option premium is its cost - how much the particular option is worth to the buyer and seller. While supply and demand ultimately determine price, other factors, which will be discussed in this tutorial, do play a role. Option traders apply these factors to mathematical models to help determine what an option should be worth. Options Pricing: Intrinsic Value And Time Value

Related Articles
  1. Investing

    Income Strategies for Your Portfolio to Make Money Regularly

    Discover the option-writing strategies that can deliver consistent income, including the use of put options instead of limit orders, and maximizing premiums.
  2. Investing

    Getting Acquainted With Options Trading

    Learn more about stock options, including some basic terminology and the source of profits.
  3. Trading

    When Should I Sell A Put Option Vs A Call Option?

    Beginning traders often ask not when they should buy options, but rather, when they should sell them.
  4. Trading

    A Guide Of Option Trading Strategies For Beginners

    Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.
  5. Markets

    Getting A Handle On The Options Premium

    The price of an option, otherwise known as the premium, has two basic components: the intrinsic value and the time value. Understanding these factors better can help the trader discern which ...
  6. Trading

    Options Hazards That Can Bruise Your Portfolio

    Learn the top three risks and how they can affect you on either side of an options trade.
  7. Trading

    Cut Down Option Risk With Covered Calls

    A good place to start with options is writing these contracts against shares you already own.
  8. Markets

    How to Trade Options on Government Bonds

    A look at trading options on debt instruments, like U.S. Treasury bonds and other government securities.
  9. Trading

    The Basics Of Covered Calls

    Learn how this simple options contract can work for you, even when your stock isn't.
  10. Trading

    The Basics of Options Profitability

    The adage "know thyself"--and thy risk tolerance, thy underlying, and thy markets--applies to options trading if you want it to do it profitably.
Trading Center