Options Pricing: The Basics Of Pricing
  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

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.

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

  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
RELATED TERMS
  1. Call Over

    When the buyer of a call option exercises the option. In options ...
  2. Premium Income

    1. In investing, income that is earned through the sale of an ...
  3. Option Premium

    1. The income received by an investor who sells or "writes" an ...
  4. Step Premium

    A type of option where the cost of purchasing the option is paid ...
  5. Pegging

    1. A method of stabilizing a country's currency by fixing its ...
  6. Time Value

    The portion of an option's premium that is attributable to the ...
RELATED FAQS
  1. How can derivatives be used to earn income?

    Learn how option selling strategies can be used to collect premium amounts as income, and understand how selling covered ... Read Answer >>
  2. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  3. What is the difference between "right" and "obligation" on a call option?

    Learn what a call option is, what determines a buyer and seller of an option, and what the difference between a right and ... Read Answer >>
  4. How are call options priced?

    Learn how aspects of an underlying security such as stock price and potential for fluctuations in that price, affect the ... Read Answer >>
  5. Does the seller (the writer) of an option determine the details of the option contract?

    The quick answer is yes and no. It all depends on where the option is traded. An option contract is an agreement between ... Read Answer >>
  6. Are there any risks involved in trading put options through a traditional broker?

    Explore put option trading and different put option strategies. Learn the difference between traditional, online and direct ... Read Answer >>
Hot Definitions
  1. Physical Capital

    Physical capital is one of the three main factors of production in economic theory. It consists of manmade goods that assist ...
  2. Labor Market

    The labor market refers to the supply and demand for labor, in which employees provide the supply and employers the demand. ...
  3. Demand Curve

    The demand curve is a graphical representation of the relationship between the price of a good or service and the quantity ...
  4. Goldilocks Economy

    An economy that is not so hot that it causes inflation, and not so cold that it causes a recession. This term is used to ...
  5. White Squire

    Very similar to a "white knight", but instead of purchasing a majority interest, the squire purchases a lesser interest in ...
Trading Center