HOW OPTIONS ARE PRICED
Plain English
An option's price isn't random. It's determined by six factors: the stock price, the strike price, time until expiration, volatility, interest rates, and dividends. Models like Black-Scholes calculate a 'fair value' based on these inputs.
Going deeper
Options pricing models (Black-Scholes, binomial) use several variables to determine fair value. The stock price relative to the strike determines intrinsic value. More time until expiration means more extrinsic value. Higher implied volatility increases the premium because bigger potential moves make the option more valuable. Interest rates and dividends also play smaller roles. Understanding these drivers helps traders evaluate whether an option is cheap or expensive relative to its theoretical value.
Examples
Volatility's Impact
Stock A and Stock B are both at $100, and you look at their $105 Calls expiring in 30 days. Stock A is a stable utility company (low volatility) — its call costs $1.00. Stock B is a volatile biotech (high volatility) — its call costs $5.00. Same setup, vastly different prices due to expected movement.
Time's Impact
A 90-day ATM call might cost $6.00. A 30-day ATM call on the same stock might cost $3.50. A 7-day ATM call might cost $1.50. More time = more premium, but the relationship isn't linear.