The following are the different Option Greeks in the market:. Delta measures the difference in the value of premium to change in the value of underlying. It defines the speed with which option would become in-the-money or out-of-the-money due to fluctuations in the underlying price. Time is an ingredient in determining the premium for a particular strike price.

Time decay reduces the option Premium as it nears expiry. Theta is the time decay factor, i. Vega v — Vega, as a greek, is sensitive to the current volatility. Volatility is the rate of change because of the changes in market volatility. Higher the volatility of the underlying asset, the more expensive it is to buy the option and vice versa for lower volatility.

Rho p — Rho is a metric used for assessing the sensitivity of an option premium to changes in the risk-free interest rate. Several factors determine the value of the premium — the underlying stock price relating to the strike price intrinsic value , the length of time until the option expires time value , and how much the price fluctuates volatility value.

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Market price, volatility, and time remaining are the primary forces determining the premium. There are two components to the options premium, and they are intrinsic value and time value. The intrinsic value is determined by the difference between the current trading price and the strike price.

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Only in-the-money options have intrinsic value. Intrinsic value can be computed for in-the-money options by taking the difference between the strike price and the current trading price.

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Out-of-the-money options have no intrinsic value. The time value is dependent upon the length of time remaining to exercise the option. The time value of an option decreases as its expiration date approaches and becomes worthless after that date. This phenomenon is known as time decay. For in-the-money options, time value can be calculated by subtracting the intrinsic value from the option price. Time value decreases as the option goes deeper into the money. The option pricing model uses variables such as stock price, exercise price, volatility, interest rate, time to expiration, to theoretically value an option.

Some commonly used models to value options are Black-Scholes, binomial option pricing, and Monte-Carlo simulation. Black-Scholes is a pricing model used to determine the fair option premium price for a call or a put option based on variables such as volatility, type of option, underlying stock price, time, strike price, and the risk-free rate.

How to Calculate an Option Premium

The quantum of speculation is more in stock market derivatives, and hence proper pricing of options eliminates the opportunity for any arbitrage. The model assumes stock prices follow a log-normal distribution because asset prices cannot be negative they are bounded by zero.

According to the Black-Scholes model, the assumption of log-normal underlying asset prices should thus show that implied volatility are similar for each strike price. The model is used to determine the price of a European call option, which means that it can only be exercised on the expiration date. The Binomial Options Pricing Model provides investors with a tool to help evaluate stock options.

The model uses multiple periods to value the option. The model simulates the options premium at two possibilities of price movement up or down. The periods create a binomial tree — In the tree, each tree shows the two possible outcomes or the price movement. The model creates a binomial distribution of possible stock prices for the option.

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It creates possible paths that the stock price could go until the expiration date and the resulting impact on the options premium. For an in-the-money put option, subtract the price of the underlying asset from the strike price. The trader is hoping that the option will gain even more value before it expires.

For this reason, an option with months until expiration will have a higher time value than an option with weeks or just days left to go. An option within hours of expiration has little to no time value. Subtract the intrinsic value from the current option premium price to get the time value. For at-the-money and out-of-the-money options, the time value is always equal to the option premium price. The intrinsic value represents the value of the option if you exercised it right now, while the time value predicts the possibility that the option will increase in value before time runs out.

For example, an option that is out of the money or at the money is associated with a higher risk of losing all value by the expiration date than with an in-the-money option. On the flip side, at-the-money and out-of-the-money options also carry the chance of becoming in the money before expiration, which would result in larger profit percentage gains than with an option that starts in the money.

Delta describes the amount an option premium changes with every one-point change in the underlying security. A call option can have a delta ranging from 0 to 1 and moves in the same direction as the underlying asset.

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A put option can have a delta between -1 and 0 and moves in the opposite direction of the underlying asset. The higher the premium price of an option, the higher the potential value that option has. Reviewing the delta of an option can help inform your strategy. As the delta of an option premium approaches 1 for a call option or -1 for a put option, the option becomes further in the money and grows more valuable.

Now that you know how to calculate an option premium, you can harness the value of this knowledge as you become acclimated to the complex yet rewarding world of options trading.

How to Do an Option Premium Calculation. Consider the Role of Delta Delta describes the amount an option premium changes with every one-point change in the underlying security. Top ads.