Why Options Cost What They Do
Options pricing really comes down to two main pieces.
Intrinsic value is what an option’s worth right now. For example, if a call option has a strike price of $50 and the stock trades at $55, you’re looking at $5 of real, tangible value.
Time value makes up the rest of the premium. It’s all about how much time is left before the contract expires. More time? More chances for things to swing your way.
Some big factors drive option prices:
- Current market price vs strike price
- Days until expiration
- How much the stock bounces around (volatility)
- Interest rates
- Dividends
Volatility is a major player in option prices. Wild stocks cost more because big moves are more likely.
Boring, steady stocks? Much cheaper options when you’re buying them, much higher profits when selling them.
The market price of the stock also matters.
If the stock rises, call options get pricier. When stocks drop, put options jump up in price.
Time isn’t on the buyer’s side. Each day chips away at the premium, and that decay really speeds up near the end.
Supply and demand can be a problem too.
If everyone wants a contract—say, right before big news—prices get high.
Intrinsic vs. Extrinsic Value: What Really Sets Option Prices?
Every option’s price breaks down into two parts: intrinsic value and extrinsic value. Together, they make up the total premium buyers pay for or sellers receive.
Intrinsic value is how much an option is “in the money.” For a call, it’s the stock price minus the strike price—if the stock’s above the strike.
Puts work the same way, just flipped: it’s the strike price minus the stock price when the stock’s below the strike.
| Option Type | In the Money When (in profit) | Intrinsic Value Calculation |
| Call | Stock > Strike | Stock Price – Strike Price |
| Put | Stock < Strike | Strike Price – Stock Price |
Extrinsic value is everything else in the price. It’s time value plus how much the stock might move before the contract’s up.
The math is easy:
Option Price = Intrinsic Value + Extrinsic Value
Let’s say a stock trades at $52, and you’ve got a $50 call worth $4. That’s $2 intrinsic ($52 – $50), and the other $2 is extrinsic—mostly time and volatility.
As expiration gets closer, extrinsic value melts away, even if the stock just sits there.
That’s time decay in action, it happens both with puts and calls.
When markets get jumpy, extrinsic values shoot up.
If traders expect chaos, they’ll pay more for options—no matter the current intrinsic value.
This is the time where option sellers benefit the most.
Time Decay (Theta): Why Options Lose Value Every Day
Every single day, option contracts lose a bit of value, even if the stock doesn’t move an inch.
Think of time decay as a countdown clock. The closer you get to expiration, the faster the value slips away.
Theta is just the number that tells you how much value an option drops daily. If theta is -0.05, you lose five cents a day, just from time ticking by.
There’s one important difference:
Long-dated options lose value slowly. Near-expiration options lose value fast.
Time decay hits people differently:
- Option buyers lose money to theta every day
- Option sellers actually collect money from theta
Avoid: The fastest decay happens at-the-money. Those options have the most time value to lose.
Focus on: Deep in-the-money or way out-of-the-money options lose less each day. They just don’t have as much time value built in.
Quick facts about theta:
| Factor | Impact |
| Days to expiration | More days = slower decay |
| Option position | At-the-money = fastest decay |
| Time remaining | Less time = faster decay |
Implied Volatility: Why Options Get Expensive Before Earnings
Implied volatility is basically the market’s guess at how much a stock might swing in the future. It’s a like a fear meter for options traders.
When earnings are coming up, nobody knows what’s about to happen. The stock could rocket or tank, depending on the news.
This uncertainty makes options more expensive.
Here comes Vega – it measures how much an option’s price jumps when implied volatility changes.
| Factor | Effect on Options |
| High uncertainty | Higher premiums |
| Low uncertainty | Lower premiums |
| Earnings approach | Volatility increases |
Before earnings, traders pile into options, expecting big price changes. Both calls and puts get pricier at the same time.
Sellers want more money to take on that risk. They know the stock might explode in either direction after the news.
As earnings day gets closer, implied volatility usually ramps up.
Once earnings drop, implied volatility almost always crashes. That’s the infamous “IV crush“—option values plummet, even if you guessed the direction right.
Some traders sell options before earnings to grab those juicy premiums. Others wait for the dust to settle and buy options when they’re cheap again.
IV Crush: How You Can Be Right and Still Lose Money
Implied volatility (IV) crush ruins a lot of trades. You pick the right direction, but still end up losing cash.
Here’s how it goes. You buy calls before earnings, the stock jumps 5%—great, right? But your options drop 20% overnight.
It feels impossible. But there’s more to options pricing than just the stock’s move.
Main Things That Move Option Prices
Several pieces are in play:
- Stock price changes (delta)
- Time decay (theta)
- Implied volatility (vega)
- Interest rates (rho)
- How fast price changes (gamma)
Delta tells you how much an option price changes when the stock moves $1. But it’s not the whole story.
Vega shows how much you lose if implied volatility tanks. High vega = more risk from IV crush.
When IV Crush Hits the Hardest
IV crush loves big events:
| Event Type | Typical IV Drop | Risk Level |
| Earnings | 40-60% | High |
| FDA approvals | 50-80% | Very High |
| Merger news | 30-50% | Medium |
Before big news, uncertainty blows up option prices. After, that uncertainty vanishes fast.
The Greeks help explain it. Delta might look good, but vega can wreck your trade. Gamma and rho matter too, just less so.
What you need to do?
Check IV before buying. If IV crush risk is huge, sometimes it’s better to just wait it out.
Bid-Ask Spread & Liquidity: What’s the Deal?
The bid-ask spread is simply the gap between what buyers want to pay and what sellers want to get. The bid’s the highest price a buyer offers. The ask’s the lowest a seller will take.
Market makers keep things moving by buying at the bid and selling at the ask. They pocket the difference, keeping the market liquid for everyone else.
Liquidity is about how easy it is to trade without moving the price. High liquidity means:
- Tight bid-ask spreads
- Lots of trading volume
- Plenty of buyers and sellers
Popular options like SPY have spreads as low as a penny or two. Thinly traded stuff? The spread can be 10% of the value, which is just painful.
The spread is a transaction cost. Wide spreads eat into your profits and bump up your trading expenses.
What makes spreads wider?
| Factor | Effect on Spread |
| High volatility | Wider spreads |
| Low volume | Wider spreads |
| Market stress | Wider spreads |
| Popular stocks | Tighter spreads |
Time to expiration matters too. Longer-term options usually have wider spreads than short-term ones.
In-the-money options often have wider spreads than at-the-money contracts. This can mess with hedging and arbitrage strategies.
Advice:
Stick to liquid markets with tight spreads. It saves money and makes trading smoother—whether you’re in futures, options, or whatever else.
