Option Pricing Basics
Understand what you're actually paying for when you buy an option. We'll break down every component of an option's price, show you why options lose value over time, and explain how positions are typically managed before expiration.
Before You Trade
These examples and charts are simplified teaching models. Confirm live pricing, liquidity, and assignment risk in your broker before placing real trades.
1. Intrinsic vs Extrinsic Value
Every option's price (the premium) is made up of exactly two components. Understanding this breakdown is the single most important concept in option pricing.
The Option Pricing Formula
Option Premium
Intrinsic Value
Extrinsic Value
Intrinsic Value
The real, tangible value of an option if you exercised it right now. It's the difference between the stock price and the strike price (when favorable). Intrinsic value can never be negative—the minimum is always $0.
Extrinsic (Time) Value
Everything in the premium above intrinsic value. It represents the market's bet that the option could become more valuable before expiration. This portion melts away over time and reaches $0 at expiration.
Simple way to remember
How to Calculate Intrinsic Value
Call Options
Intrinsic Value = Stock Price − Strike Price
(If negative, intrinsic = $0)
Stock = $55, Strike = $50: Intrinsic = $5
Stock = $48, Strike = $50: Intrinsic = $0
Put Options
Intrinsic Value = Strike Price − Stock Price
(If negative, intrinsic = $0)
Stock = $45, Strike = $50: Intrinsic = $5
Stock = $52, Strike = $50: Intrinsic = $0
Call Option — Intrinsic Value vs Stock Price
Intrinsic value of a call option across different stock prices. Below the strike ($50), intrinsic value is zero. Above it, intrinsic value increases dollar-for-dollar.
Illustrative example only: chart values are simplified to teach mechanics and are not live quotes or trade forecasts.
Breaking Down a Real Price
Example: AAPL $150 Call trading at $8.50
AAPL stock is currently at $155. The $150 call option is trading at $8.50.
• Intrinsic value: $155 − $150 = $5.00
• Extrinsic value: $8.50 − $5.00 = $3.50
You're paying $5.00 for the real value and $3.50 for time and possibility. That $3.50 will decay to $0 by expiration.
Option Premium Breakdown — Intrinsic vs Extrinsic
A call option's total premium broken into intrinsic (green) and extrinsic (amber) components. Notice extrinsic value peaks near the strike price.
Illustrative example only: chart values are simplified to teach mechanics and are not live quotes or trade forecasts.
Based purely on the stock price vs strike price. Only exists when the option is in the money. Does not change with time—only with stock price movement. This is the 'real' value.
Driven by time remaining, volatility, and demand. Highest at-the-money, lowest deep ITM or OTM. Always decays to zero at expiration. This is the 'hope' value you're paying for.
2. Time Value Deep Dive
Time value (also called extrinsic value) is the extra amount buyers are willing to pay above intrinsic value. It reflects the probability that an option could become more profitable before expiration.
What Drives Time Value?
Time
Time to Expiration
More time = more time value. A 90-day option costs more than a 30-day option (all else equal) because there's more time for the stock to move favorably.
IV
Implied Volatility
Higher expected stock movement = more time value. If a stock could swing ±20%, options are worth more than if it only moves ±5%.
ATM
Distance from Strike
At-the-money options have the most time value. Deep ITM or OTM options have less because the probability of a meaningful change is lower.
Key insight: Time value and square root of time
Time Value Erosion — ATM Option Over 90 Days
Option value decays following a square-root curve. Notice how the decline accelerates dramatically in the final 30 days.
Illustrative example only: chart values are simplified to teach mechanics and are not live quotes or trade forecasts.
Time Value by Expiration Length
Compare ATM options with different expirations. Notice that more time doesn't mean proportionally more value—it follows the square root rule.
7 days
$1.39
28% of 90-day
30 days
$2.89
58% of 90-day
60 days
$4.08
82% of 90-day
90 days
$5.00
100% of 90-day
Example: Why time value matters for your trades
You buy a $100 call on XYZ for $4.00 with 45 days to expiration. The stock is at $100 (ATM), so the entire $4.00 is extrinsic value. Even if XYZ stays at exactly $100 for 30 days, your option will have lost about $2.45 in value—over 60% of your investment—just from the passage of time. The stock didn't move against you, but you still lost money.
3. Why Options Decay
Options decay because of a Greek called theta (Θ). Theta measures how much value an option loses each day, all else being equal. Understanding theta is critical because it's the silent force constantly working against option buyers.
The Mechanics of Theta Decay
Think of an option as an ice cube. On day one, the ice cube is large. As time passes, it melts slowly at first. But as the cube gets smaller, the ratio of surface area to volume increases—so it melts faster and faster. Options behave the same way.
Days 90 to 60
−$0.03/day
Slow, gentle decay
Days 30 to 15
−$0.06/day
Accelerating decay
Days 7 to 0
−$0.14/day
Rapid meltdown
Daily Theta — Decay Rate Over Time
Daily theta (decay per day) increases dramatically as expiration approaches. The last 2 weeks are where option buyers lose the most to time decay.
Illustrative example only: chart values are simplified to teach mechanics and are not live quotes or trade forecasts.
Why Does This Happen?
Option pricing models (like Black-Scholes) price the probability that an option will finish in the money. As expiration nears, there's less time for the stock to make big moves, so the probability of an OTM option becoming profitable shrinks rapidly.
Less time = fewer possible outcomes
With 90 days left, a stock could easily move $20. With 5 days left, a $20 move is very unlikely. Fewer possible favorable outcomes means lower option value.
Uncertainty has value
Option buyers pay for uncertainty—the chance something big might happen. As time passes, that uncertainty resolves and the "hope premium" evaporates.
Theta accelerates because of math
Time value follows the square root of time. The derivative of √t is 1/(2√t), which gets larger as t approaches zero. This is why the decay curve looks like a hockey stick.
Theta works for sellers, against buyers
Theta Decay: Week-by-Week Breakdown
Here's how a $5.00 ATM option loses value over 90 days, assuming the stock price doesn't change:
| Period | Value Start | Value End | Lost | % of Total |
|---|---|---|---|---|
| Day 1–30 | $5.00 | $4.08 | $0.92 | 18% |
| Day 31–60 | $4.08 | $2.89 | $1.19 | 24% |
| Day 61–75 | $2.89 | $2.04 | $0.85 | 17% |
| Day 76–85 | $2.04 | $1.18 | $0.86 | 17% |
| Day 86–90 | $1.18 | $0.00 | $1.18 | 24% |
The 45-DTE rule
4. Moneyness: ITM / ATM / OTM
Moneyness describes the relationship between a stock's current price and an option's strike price. It tells you whether an option has intrinsic value and dramatically affects how the option is priced.
In the Money
(ITM)
The option has intrinsic value. Exercising it would be profitable (ignoring the premium).
Call: Stock $55 > Strike $50 (ITM)
Put: Stock $45 < Strike $50 (ITM)
At the Money
(ATM)
Stock price ≈ strike price. The option is at the tipping point and has the highest extrinsic value.
Call: Stock $50 ≈ Strike $50 (ATM)
Put: Stock $50 ≈ Strike $50 (ATM)
Out of the Money
(OTM)
The option has no intrinsic value. It's entirely made up of extrinsic (time/hope) value.
Call: Stock $45 < Strike $50 (OTM)
Put: Stock $55 > Strike $50 (OTM)
How Moneyness Affects Price Composition
The chart below shows how a call option's extrinsic value (amber) peaks right at the money and decreases as you move deeper ITM or OTM. Intrinsic value (green) only appears on the ITM side.
Call Option Value Composition by Stock Price
Extrinsic value peaks at-the-money (strike = $100). ITM options have both intrinsic + extrinsic. OTM options are pure extrinsic value.
Illustrative example only: chart values are simplified to teach mechanics and are not live quotes or trade forecasts.
Moneyness at a Glance — $60 Strike Call
This table shows how the premium of a $60 strike call option breaks down at various stock prices:
| Stock Price | Moneyness | Intrinsic | Extrinsic | Total Premium |
|---|---|---|---|---|
| $45 | Deep OTM | $0.00 | $0.15 | $0.15 |
| $55 | OTM | $0.00 | $1.20 | $1.20 |
| $60 | ATM | $0.00 | $3.50 | $3.50 |
| $65 | ITM | $5.00 | $2.10 | $7.10 |
| $75 | Deep ITM | $15.00 | $0.80 | $15.80 |
Why ATM options have the most extrinsic value
Moneyness for Puts — It's the Mirror Image
For put options, the moneyness is reversed. A put is ITM when the stock is below the strike and OTM when the stock is above the strike:
Call Moneyness
ITM: Stock above strike
ATM: Stock equals strike
OTM: Stock below strike
Put Moneyness
ITM: Stock below strike
ATM: Stock equals strike
OTM: Stock above strike
5. Expiration Outcomes: Closed, Exercised, or Expired
Options can end in three ways: closed before expiration, exercised/assigned, or left to expire. The split below is a teaching example to show how those outcomes differ in practice. Actual rates vary widely by product, strategy, and market regime.
72%
Closed Before Expiration
22%
Expire OTM
6%
Exercised / Assigned
How to read this example split
Closed before expiration — Most positions are exited with closing trades to realize gains/losses and avoid expiration surprises.
Expire OTM — Contracts that finish out of the money end with no intrinsic value at expiration.
Exercised / assigned — In-the-money contracts can convert into stock obligations, especially near expiration.
Why Many Long Options Still Lose Money
Cheaper OTM contracts need larger moves
Low-cost out-of-the-money options can look attractive, but they require bigger and faster price moves to become profitable.
Theta can outrun your thesis
Time decay reduces option value each day. Even a correct directional idea can underperform if the move arrives too slowly.
Volatility can contract after catalysts
After events like earnings, implied volatility can drop quickly. That IV crush can offset gains from a modest stock move.
Execution quality matters
Wide bid/ask spreads, poor fills, and late exits can turn a marginal setup into a losing trade even when direction is mostly right.
Why Premium Sellers Focus on Process
Selling premium can benefit from time decay, but it is not a free edge. Results depend on position sizing, strike selection, volatility context, and disciplined risk management. That is why strategies like covered calls, cash-secured puts, and iron condors are rules-driven.
Pays premium upfront and seeks convex upside. Must be right on direction, timing, and often volatility.
Collects premium upfront and benefits from time decay, but must control tail risk and avoid oversized losses.
How Theta Tracker helps
6. Pricing Walkthroughs
Let's walk through several real-world scenarios to cement your understanding of option pricing. Each example breaks down the premium into its components.
Example 1: ITM Call Option
Stock: MSFT at $420
Option: $400 Call, 30 DTE
Premium: $25.50
Intrinsic: $20.00 ($420 − $400)
Extrinsic: $5.50 ($25.50 − $20.00)
Moneyness: ITM by $20
This deep ITM option is mostly intrinsic value. The $5.50 of extrinsic will decay to $0 over the next 30 days. It moves almost dollar-for-dollar with the stock.
Example 2: ATM Put Option
Stock: AAPL at $175
Option: $175 Put, 60 DTE
Premium: $7.80
Intrinsic: $0.00 (stock = strike)
Extrinsic: $7.80 (all time value)
Moneyness: ATM
This ATM option is 100% extrinsic value. If AAPL stays at $175 for 60 days, the entire $7.80 premium ($780 per contract) will evaporate. AAPL needs to drop below $167.20 for the buyer to profit.
Example 3: OTM Call — The “Lottery Ticket”
Stock: TSLA at $250
Option: $300 Call, 14 DTE
Premium: $0.45
Intrinsic: $0.00 (stock < strike)
Extrinsic: $0.45 (all hope value)
Moneyness: OTM by $50
This cheap OTM option is a long shot. TSLA needs to jump 20% in 14 days for this to have any intrinsic value. The $0.45 is pure “hope premium”—and it's very likely to expire at $0 if the move never comes.
7. Key Terms Glossary
Intrinsic Value
The portion of an option's price that reflects real, exercise value. For calls: max(0, stock − strike). For puts: max(0, strike − stock).
Extrinsic Value
The portion of the premium above intrinsic value, driven by time, volatility, and probability. Also called time value.
Time Value
Another name for extrinsic value. Represents the cost of time and uncertainty remaining until expiration.
Theta (Θ)
The Greek that measures daily time decay. A theta of −0.05 means the option loses $0.05 per day (or $5 per contract).
In the Money (ITM)
An option with intrinsic value. Calls: stock > strike. Puts: stock < strike.
At the Money (ATM)
Stock price ≈ strike price. These options have the most extrinsic value and roughly 50% probability of finishing ITM.
Out of the Money (OTM)
An option with no intrinsic value. Calls: stock < strike. Puts: stock > strike. Entire premium is extrinsic.
Moneyness
The relationship between the stock price and the strike price. Describes whether an option is ITM, ATM, or OTM.
Premium
The total price paid for an option. Equal to intrinsic value + extrinsic value.
Time Decay
The process by which an option's extrinsic value erodes as expiration approaches. Accelerates in the final weeks.
Implied Volatility (IV)
The market's expectation of future stock movement, baked into option prices. Higher IV = more expensive options.
Black-Scholes Model
The foundational mathematical model for pricing European-style options, factoring in stock price, strike, time, volatility, and interest rates.
Ready to profit from time decay?
Now that you understand how options are priced and why they decay, put this knowledge to work. Theta Tracker helps you monitor theta decay and track your option selling strategies.
Who This Is For
Beginners who understand what calls and puts are and want to learn how option prices are determined.
Learning Objectives
- • Distinguish between intrinsic value and extrinsic (time) value in an option's price.
- • Explain how time decay (theta) accelerates as expiration nears.
- • Define moneyness: in-the-money (ITM), at-the-money (ATM), and out-of-the-money (OTM).
- • Understand how expiration outcomes differ between closing early, exercising, and expiring OTM.
Example Walkthrough
Scenario: XYZ stock is trading at $105. You are looking at the XYZ $100 call with 30 days to expiration, priced at $7.50.
Pricing breakdown
Intrinsic value = $105 − $100 = $5.00 (the option is $5 in-the-money).
Extrinsic value = $7.50 − $5.00 = $2.50 (time value plus volatility premium).
Best case: XYZ rises to $115
Intrinsic value = $15. Even as extrinsic decays, your profit = ($15 − $7.50) × 100 = $750.
Worst case: XYZ drops to $98 at expiration
The $100 call is now OTM. Intrinsic = $0, extrinsic = $0 at expiration. You lose the full $7.50 × 100 = −$750. The extrinsic value you paid is gone, and there is no intrinsic value to save the trade.
Common Mistakes
Overpaying for extrinsic value
Buying far OTM options because they are 'cheap' ignores that they are almost entirely extrinsic value—money that evaporates with time.
Ignoring theta acceleration
Time decay is not linear. The last 30 days destroy extrinsic value much faster than the first 30. Buying short-dated options without accounting for this leads to fast losses.
Confusing ITM with profitable
An ITM option still has a breakeven. If you paid $7.50 for a $5 ITM call, the stock must move another $2.50 in your favor just to break even.
Not understanding moneyness shifts
An OTM option can become ITM if the stock moves. A seemingly worthless option can gain value quickly—but time decay is always working against the buyer.
Quick Recap
- • An option's price = intrinsic value (how much it is ITM) + extrinsic value (time and volatility premium).
- • Time decay (theta) accelerates as expiration approaches, eroding extrinsic value faster each day.
- • Moneyness (ITM, ATM, OTM) determines how much intrinsic value an option has and how sensitive it is to price changes.
Next lesson
Option Chains & Quotes
Up nextLearn to read option chains, analyze bid/ask spreads, volume, open interest, and choose strikes and expirations.
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