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The Components of An Option's Price 
The premium of an option is expressed on a per-share basis. To arrive at the dollar amount one has to pay to own, for example, a stock option, one has to multiply the quoted price by 100 shares of stock, which is the amount that the option entitles one to sell or buy. 

The premium of an option has two components: 

  • Intrinsic Value 

    • The price at which the option owner is allowed to either buy or sell the underlying asset is called the strike price. If the strike price of the call option is below the current market price of the underlying asset, the option is said to be in the money, since the option holder, by exercising the option, can buy the underlying asset below its current market price. A call option that has the same strike price at the current market price is said to be at the money. A call option that has a strike price above the underlying asset's current market price is said to be out of the money. 
    Example: With the underlying stock at $42.50, the call option with the $40 strike price is in the money. The option with the $45 strikie price is out of the money. 
    For put options, the reverse is true. When the underlying stock's price is below the put option's strike price, the put is in the money. If its current market value is above the option's rice, then it is said to be out of the money. The value that the option holder would receive by exercising the option is known as the intrinsic value. If the option is out of the money, then the intrinsic value is zero. 
    • Time Value 

      • Intrinsic value is only one component of option pricing, The other is time value, which is equal to to the option price less the intrinsic price. 
    Example: The price of an XYZ 40 call option is 4 ($400), with XYZ trading at 42. The owner of this option can immediately recoup $200 of the option's price by: 
    Exercising the option, that is buying the stock at $4000 and immediately selling it in the open market for $4200. The option therefore has $200 of intrinsic value. In addition, the time value is $400 (price of option) -$200(intrinsic value)  = $200 (time value) as well. 
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    This page is created by Julia Lee '99 and is maintained by Professor Satyananda Gabriel of the Economics Department, Mount Holyoke College, January 1999.