Definition: Option premium is the price that is paid to acquire an option. The terms option price and option premium are interchangeable. An option’s value is driven by volatility, moneyness, and days until expiration. Intrinsic value and time value are the two main components that determine the option’s premium.
Option Premium = Intrinsic Value + Extrinsic Value (Time Value & Implied Volatility)
ITM options are the only ones with intrinsic value. OTM options don’t have any intrinsic value and priced based on only time value and implied volatility. To determine the intrinsic value of an ITM option, take the difference between the current market price of the underlying asset and the strike price.
Intrinsic Value of ITM Call = Current Market Price – Strike Price
Intrinsic Value of ITM Put = Strike Price – Current Price
The extrinsic value of an option is made up of two portions. One portion is the time value of the option which is determined by the DTE (days till expiration). The further out an option is from its expiration equates to a higher time value. The other half of the equation is IV (implied volatility). As the IV expands, the volatility portion of the option is worth more.
Time value is also known as the theta decay portion. Options slowly lose value over time as they approach their expiration date. Theoretically if all else stays equal, an option loses time value on a daily basis up until the option expires. The further out from the expiration cycle, the less an option loses in daily time value. As options approach their expiration, theta decay starts to accelerate.
Implied volatility is the projected movement in price of the underlying asset. An underlying asset with high IV will have more expensive options. On the other hand, an option will be less expensive if the underlying has low IV.
For ITM options, subtract out the intrinsic value of the option to be left with the extrinsic value.
For OTM options, the option price is just extrinsic value.
(The graph above shows the effect of theta decay over the life-time of an option)