Pricing Options
Options are priced by looking at probabilities.
There are complicated mathematical processes, such as the Black Scholes model, that are used to evaluate the probabilities and hence calculate Options prices. We will not be looking at such techniques here though; instead we will look at the principles of how Options are priced.
The following are some sample mid-prices for Call Options on the FTSE® 100 for different expiry months (the underlying FTSE® 100 price is 6220):
| Strike | February | March | June |
|---|---|---|---|
| 6150 | 135 | 158 | 258 |
| 6200 | 105 | 131 | 228 |
| 6350 | 44 | 72 | 163 |
| 6375 | 35 | 62 | 151 |
| 6400 | 28 | 53 | 139 |
As can be seen, some Options are more expensive than others. Why is this?
The Options prices are clearly affected by two factors: the underlying price and the amount of time that is left to expiry.
Underlying price
If we compare the February 6200 Call with the February 6350 Call we can see that the 6200 Call is priced at 105 whereas the 6350 Call is only worth 44.
Calls are the right to buy. The right to buy at 6200 is more desirable than the right buy at the higher price of 6350, and consequently the value is greater.
But why is the 6200 Call priced at 105?
The right to buy at 6200 when the market is at 6220 must be worth at least 20, which explains a portion of the premium. This part of the premium is called the intrinsic value. It measures how much of the Option is immediately valuable.
There is another 85 points of premium to explain though. Where does this come from?
Time left to expiry
The extra premium on top of the intrinsic value is called the time value (it is also sometimes called extrinsic value).
The longer the amount of time remaining to expiry, the greater the chance of further movements in the underlying and therefore the probability that the Option may acquire intrinsic value. In other words, it is a function of probability.
The value of the 6200 Call in the table is therefore made up of both intrinsic value and time value.
Option premium = intrinsic value + time value
Not all Options have intrinsic value. In the table, only the 6150 and 6200 Calls have intrinsic value. At expiry, with the underlying at the same price (i.e. 6220) all the other strikes would be worthless (time value = 0 at expiry). All their current value reflects that the price of the underlying may change between now and the expiry.
Options which have intrinsic value are described as being in-the-money.
Options which have no intrinsic value, and therefore only have time value, are described as being out-of-the-money.
Another term which is often used is at-the-money. This simply refers to the Option which has the closest strike price to the price of the underlying.