Options Pricing: The Basics Of Pricing

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.

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.