Part 7 Trading Master Class With Experts

Option Pricing: Understanding the Premium

Option prices are determined by several variables, most famously modeled using the Black-Scholes formula. The main components are:

Underlying Price: The current price of the asset.

Strike Price: The agreed-upon price for the option.

Time to Expiry: Longer durations increase premium due to higher uncertainty.

Volatility: Measures how much the underlying asset’s price fluctuates; higher volatility increases option prices.

Interest Rates and Dividends: Minor but relevant factors affecting option pricing.

Option premium = Intrinsic Value + Time Value

As expiration approaches, the time value declines—this is called time decay (Theta). This is why option sellers often benefit from the passage of time if prices remain stable.