Investors love options because they enhance dozens of market strategies. Think a stock is going to rise? If you’re right, buying a call option gives you the right to buy shares later at a discount to the market value, profiting from the rise. Want to lower risk if your stock unexpectedly plummet? Acquiring a put option gives you the ability to sleep easy, knowing you can sell it later at a pre-determined price and limit your losses. 

Options can open the door to big gains or provide a safeguard against possible losses. And, unlike buying or short-selling shares, you can obtain a significant position with modest upfront capital. Whether you’re buying or selling these contracts, understanding what goes into an option’s price, or premium, is essential to long-term success. Bottom line: the more you know about the premium, the easier it will be to recognize a good deal or back out of a transaction because the odds are against you.

Intrinsic Value

There are two basic components to an option's premium. The first is the contract's intrinsic value, which signifies the difference between the strike or exercise price (the price you can buy or sell an underlying asset) and the asset's current market value.

For example, you buy a call option for XYZ Company with a strike price of $45. If the stock is currently valued at $50, the option has an intrinsic value of $5 ($50 - $45= $5). In this case, you could buy the call and exercise it right away, reaping at $500 profit ($5 x 100 shares) This known as in the money.

However, if you buy a call option for XYZ with a strike price of $45 and current market value is only $40, there is no intrinsic value. That is known as being out of the money or under water.

The second component of an option's premium now comes into play, detailing the length of the contract.

Time Value

Your options contract may be out of the money but eventually have value due to a significant change in the underlying asset's market price. This is known as the contract's time value. Roughly translated, it signifies whatever price an investor is willing to pay above the contract's intrinsic value, in hopes the investment will eventually pay off.

For example, you buy the XYZ call option with a strike price of $45 and the underlying plunges to $40. You're now out of the money but, in a month or two, the stock might rally to $50 and generate a $5 per share profit.

The option's pricing includes your bet the stock will pay off over time. If you bought a call option for $45 and it had an intrinsic value of $5 (the stock was selling at $50), you might be willing to pay an extra $2.50 to hold the contract, expecting the underlying to add to gains. That would make the option's premium $7.50 ($5 intrinsic value + $2.50 time value = $7.50 premium).

The option's premium is constantly changing, depending on the price of the underlying asset and the amount of time left in the contract. The deeper a contract is in the money, the more the premium rises. Conversely, if the option loses intrinsic value or is out of the money, the premium falls.

The amount of time left in the contract also affects the premium. For example, the premium will drop as the contract gets closer to expiration, other factors being equal.

Measuring Volatility

While premiums tend to decline as expiration nears, the pace of the decline can vary considerably. This time decay marks a major component in the contract’s time value computation.

You’re probably not going to pay a large sum for a blue chip's call or put in the 30-day window before expiration because odds for large scale price movement are limited in this relatively short period. Consequently, its time value will taper off well ahead of expiration.

Option premiums for lower capitalized securities, like hot growth stocks, tend to decay more slowly. With these instruments, odds for an out of the money option reaching the strike price are substantially higher, so the option holds its time value longer.

Due to these variations, the option trader should measure the stock’s volatility before placing a bet. One common way to accomplish this task is by looking at the equity’s standard deviation. Based on historical data, standard deviation measures the degree of movement up and down in relation to the mean price. A lower number indicates a relatively stable stock i.e. one that usually commands a smaller options premium.  

Another way to gauge volatility is by determining its beta, or comparing the stock’s fluctuations to the market as a whole. A beta above 1 represents an equity that tends to rise and fall more than the S&P 500 or another broad index. This propensity for wider range price movement means the related options contracts will usually carry a higher price tag. An equity with a beta less than 1 is comparatively stable and thus likely to carry a smaller option premium.

These yardsticks are by no means perfect because a stock's past performance doesn't always predict future results. In addition, one-time events can make stocks look more unpredictable than they really are. However, volatility measurements can be very useful in determining a company's price stability.

The Bottom Line

Options support a variety of market strategies for the seasoned investor but they do carry risks. A solid understanding of pricing factors, including volatility, increases the odds they’ll pay off with higher returns.