Having looked at the basic profit/loss characteristics of call and put options we now need to know something about the price of the option – the premium – and how it is arrived at.

Options pricing is highly complicated and mathematical but it is important to understand some of the basic principles underlying it because:

• As an options buyer, you want to have some idea of why you are paying what you are paying for an option.   
• As an options seller you want to have some idea of why you receiving what you are receiving for an option.

What is more, because most options are ‘closed out’ – bought or sold - before expiry, you need to have an idea of how an option’s price is likely to behave between opening the position and expiry.

There are three key factors in options pricing.

1. Intrinsic value

The options we have looked at so far have been what are called ‘at the money’ options. That is to say, we have examined their profit/loss characteristics assuming a start point where the exercise price is equal to the price of the underlying security.

We then looked at situations where the option moved into either profit – ‘in-the-money’ positions - or loss - ‘out of the money’ positions’. 

The amount by which an option is ‘in’ or ‘out’ of the money is referred to as its ‘intrinsic value’, and it is a key determinant of the price of the option, the premium.

Obviously, if an option is ‘in-the-money’ it will cost more than an option which is ‘out-of-the-money’. This is because it has more intrinsic value. However, intrinsic value is not the only factor that plays a part in determining the price of an option. 

2. Time value

Another important factor is the amount of time an option has until it expires. This is important because the more time there is until expiry, the more time there is for the option to move into a profitable position. This is known as the time value of the option and it reduces the closer the option gets to expiry.

The more time an option has to expiry, the more expensive it is likely to be because the more time there is for the option to move into a profitable position.

So an options price is determined by both intrinsic value and time value. But there is another important factor too.

3. Volatility

The final factor we need to consider is the volatility of the price of the underlying security that the option is written on. Why is this important?

It is important because, as with time value, the more price volatility an underlying security exhibits, the more chance there is that it will move in a profitable direction for the option buyer. For this reason, option writers will price high volatility into the premiums they charge.

So we know something about the profit/loss characteristics and also we have some idea of the factors that are going to affect the option’s price. Now let's look at some of the different ways you might use options.