"When is an option expensive or cheap?"

"Could you please explain how to price an option. That means how to know that the option is expensive or cheap. "

- Asked By Bibhu on 25 March 2009

Answered by Mr. OppiE

Hi Bibhu,

How does one tell if an option is expensive or cheap? Everyone knows when a loaf of bread is expensive or cheap just by looking at its price in comparison with another loaf of bread of equal value. However, such a comparison cannot be applied in options trading. In fact, an option with a higher price may actually be cheaper than an option with a lower price!

In order to understand why that is so, we need to first understand what stock options are and how they are priced.

First of all, stock options are just contracts between you and the seller of the contract. You pay a price to own that contract, much like paying for a lottery ticket. If the stock did not move in your favor, the price you pay for the contract goes to zero, again, like a lottery ticket. The tricky part is when stock options have strike price that are in the money. In the money stock options have strike prices that already include a part of the value of the stock in it, known as the intrinsic value. For example, a call option with a $9 strike price based on a stock that is now trading at $10, has an intrinsic value of $1 since it allows you to buy the stock $1 cheaper than the market. That $1 will be included in the price of the stock option contract along with a price you pay for the contract, known as the premium or extrinsic value. In this case, that call option with $9 strike price might be selling for $1.50. With $1 being the intrinsic value and $0.50 being the extrinsic value or the price you pay for the contract.

So far, you would have realized that the real cost of a stock options contract is in the extrinsic value, not the intrinsic value. The extrinsic value is the part which will gradually become zero as expiration of the stock options contract nears. Which means that if you bought the above call options contract and the stock remained at $10 all the way to expiration of those call options, those call options will be worth $1 at expiration because the intrinsic value of $1 only changes as the stock price changes. The extrinsic value of $0.50 will be gone due to what we call time decay.

Extrinsic value is like the price you pay to own a lottery ticket. It is the real cost of an option!

For instance, a stock is trading at $10. Its $11 strike price call option is asking for $0.80 while its $9 strike price call option is asking for $1.50. Which is more expensive? If you merely looked at the price of the option itself, it may seem like the $9 strike price call option is more expensive, right? That is wrong. Remember, the real cost of an option is its extrinsic value. The $11 strike price call options are out of the money, which means that it does not have any built in value due to the fact that it allows you to buy the stock at a higher price. All of its price is extrinsic value, which is $0.80. A $0.80 lottery ticket. However, the $9 strike price call option has $1 of intrinsic value built into it and therefore, its real extrinsic value is only $0.50! Now, compare $0.80 extrinsic value and $0.50 extrinsic value, which is more expensive?

Now, you would also have realized that options with a further expiration date tend to have higher extrinsic value as well, which means that options with a longer expiration tend to be more expensive than options with a shorter expiration. This is rightfully so since options with a longer expiration allows the stock more time to move in your favor. Its all fair deal in Options Trading.

So far, we have talked about how to tell if an option is expensive or not by comparing it with other options of the same stock. How about comparing options of the same strike price with other stocks of the same price? You would notice that even if two stocks are at exactly the same price, their options of the same strike price would not have the same extrinsic value. This is because there are 4 factors taken into consideration when computing the extrinsic value of an option. These factors are taken into consideration using a mathematical options pricing model known as the Black-Scholes Model.

Comparing the price of an option against the theoretical price generated by the Black-scholes Model is another way to find out if an option is expensive or not. This method is widely used by options writers who wants to short options with a higher than theoretical extrinsic value.

In conclusion, the real component in the price of an option that determines if it is expensive or cheap is its extrinsic value, that part which decays over time to eventually become zero when the expiration date for that option arrives. So make sure you compare the extrinsic value and not the price of an option if you wish to know if an option is expensive or not. Please read the full tutorial on Stock Options Pricing and the Black-scholes Model.

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