What makes an option cost more

Two parts of every price

Every option's premium has two parts:

Premium = intrinsic value + time value.

• Intrinsic value is what the option would be worth if it ended right now. Sunny Slice is at $30. A $25 call lets you buy at $25 something worth $30, so it has $5 of intrinsic value. A $32 call has none: why buy at $32 when the market price is $30?
• Time value is everything else. It's what you pay for the chance that things change before the option ends. It's hope, measured in dollars.

Some handy words: a call with a strike below the stock price is in the money. A call with a strike above the stock price is out of the money. A strike right about at the stock price is at the money. (For puts, flip it.)

Dial 1: distance from the price

Sunny Slice at $30, 2 months left. Here are made-up but realistic call prices:

• $25 call: about $5.25 ($5 intrinsic + $0.25 time)
• $28 call: about $2.75
• $30 call: about $1.55
• $32 call: about $0.80
• $35 call: about $0.20
• $40 call: about one penny

The farther the strike is from the price, the cheaper the option, because it's less likely to pay off. A cheap option isn't a bargain. It's cheap because it will probably end up worthless, like a lottery ticket.

Dial 2: time left

The same $32 call, with different amounts of time left:

• 1 week: a few cents
• 1 month: about $0.40
• 2 months: about $0.80
• 6 months: about $1.95

More time means more chances for a big move, so it costs more.

And here's the tricky part. Time value melts like an ice cube in the sun: slowly at first, then faster and faster near the end. That's time decay. An at-the-money option worth about $1.90 with 90 days left is still worth about $1.10 with 30 days left. Then it loses that whole $1.10 in the last month. It drops more in the final month than in the two months before it put together.

Dial 3: how jumpy the stock is

Volatility means how much a stock usually swings. A jumpy stock is more likely to make a big move, so its options cost more.

The same $32 call, 2 months left, stock at $30:

• A calm stock (like Slow Steady Soup): about 17 cents
• A normal stock (like Sunny Slice): about $0.80
• A very jumpy stock (like Rocket Robots): about $3.15

Same strike, same time, same stock price, and one costs about 18 times more than the other.

Traders look at implied volatility, or IV: how jumpy the market expects the stock to be from now on, worked out from option prices. When people are scared or big news is coming, IV goes up and options get pricier.

The earnings trap

Before an earnings report, IV usually climbs, because everyone expects a big move. Right after the report, IV usually drops fast. That's called IV crush.

So you can buy a call before earnings, be right that the stock goes up, and still lose money. Say the call cost $1.50 before the report. The stock rises $1, but IV collapses, and the next morning the call is worth only $1.20.

Small dials

Interest rates and dividends nudge option prices a little too, but for most beginners they matter much less than the big three.

Putting it together

• Expensive option: close to (or past) the stock price, lots of time, jumpy stock.
• Cheap option: far from the price, little time, calm stock.

Cheap usually means unlikely. Option buyers have to be right about direction, size and timing, while time decay nibbles at them every single day.

Remember

• Premium = intrinsic value + time value.
• The farther the strike from the price, the cheaper the option, because it's less likely to pay off.
• More time costs more, and time value melts fastest near expiration.
• Jumpy stocks have pricier options, and IV often drops right after big news.