What Are The Basics of Options Pricing? How Do I Know If I’m Getting Ripped Off?
Option prices have two key components every trader should understand. The value of an option, like a call or a put, consists of the intrinsic value and the extrinsic value. The value of options is called the premium price. This price is used when trading options and is an important consideration when hedging your portfolio.
Intrinsic value
The intrinsic value is a fancy way for saying the amount of cash you can see its worth — in other words, the difference between the strike price and the current market price of the asset (with a lower bound of 0). For calls, if the asset price is greater than the strike price, then the intrinsic value equals asset price minus strike price, simple as that. If you own a 1 ETH Call with a strike of 1,500 and the current price is 1,700, then your intrinsic value is 200 (multiplied by the size of the asset, so 1 for this example). And if you own a 5 ETH put with a strike price of 1,800 and ETH is valued at 1,700, your intrinsic value is 100 x 5 (size) = 500. Be sure to consider your contract size in the pricing!
Extrinsic Value
The Extrinsic value is not easily determined, as it is a derived value from the market forces. The extrinsic value consists of the Time Value of the option and the Volatility Value of the option (described in the ‘greeks’).
Time value
The Time Value of an option represents how the more time that is left until expiration implies a higher value required. This makes sense — more time means more time for the option to be exercised in the money, so the option writer requires a higher premium for more time.
Volatility value
The Volatility Value of an option describes how volatile the underlying crypto to crypto prices are. The more volatile the pair is, the higher the volatility value. This makes sense — if the crypto is more volatile, then there is a statistically higher chance that the option will be exercised in the money and thus requires a higher premium from the option writer for that higher risk the writer is taking on.
These time and volatility values are not directly calculated — but instead, you can calculate them based on what an option writer is willing to receive for the premium price (the ask). The math can be complex, and there is a whole theory written about it by two economists, Black and Scholes, who derived the Black Scholes model for options pricing. We will not go into that here. However, Hedgey is planning to build an analytics platform that details these analytics and options pricing.
Summary
Together the value of the option is the intrinsic plus the extrinsic value. When looking at options, you should never sell your in the money options for less than the extrinsic value, as there is an immediate arbitrage opportunity. And it would be best if you take caution when looking at out of the money options, as the volatility of certain cryptocurrencies can drive the intrinsic value higher than normal — leading to increased price premiums.
