How Options Are Priced

When a covered call fund says it “collected 1.2% in premium this month,” where does that number come from? Why do some options cost a few cents and others several dollars? Option prices follow a logic that’s surprisingly easy to grasp once you see the pieces. You don’t need to calculate them; you just need to know what moves them.

Every premium has two parts

Intrinsic value is what the option would be worth if it expired right now. A $50 call on a $55 stock has $5 of intrinsic value, because you could buy at $50 and sell at $55. An out of the money option has no intrinsic value at all.

Time value (also called extrinsic value) is everything above that: the price of the possibility that the stock moves further in the buyer’s favor before expiration. Out of the money options are pure time value.

What makes an option expensive

Here are some real looking examples for calls on a $100 stock, using the standard Black-Scholes pricing model:

Look at the last row. Doubling the volatility nearly quadrupled the price of the out of the money call. That’s why single stock option funds built on very volatile shares can pay such enormous distributions, and why their risks are just as large.

Implied volatility, in plain English

Implied volatility (IV) is the market’s guess at how much a stock will swing over the life of the option, expressed as a yearly percentage. It’s “implied” because it’s worked out backwards from the prices people are actually paying.

• A sleepy utility might have an IV around 15% to 20%.
• The S&P 500 often sits between 12% and 25%. The VIX index measures exactly this.
• A volatile tech or crypto linked stock can have an IV of 60% to over 100%.

IV jumps when investors are scared, which is why covered call funds often collect their biggest premiums right after a sell off. Historically, implied volatility has tended to be a little higher than the volatility that actually followed. That gap, sometimes called the volatility risk premium, is the long-run edge option sellers are trying to collect. It’s real, but it’s small, and it disappears in the moments that matter most: crashes and sudden spikes.

Time decay

Time value shrinks as expiration approaches, and it shrinks faster near the end. An option with 90 days left loses its value slowly; one with a week left melts quickly. Traders call this theta. For the buyer it’s a cost that ticks every day. For the seller it’s the income. Play with the sliders and watch the decay curve.

Delta: a handy shortcut

Delta tells you how much an option’s price moves when the stock moves $1. A call with a delta of 0.30 gains about 30 cents if the stock rises a dollar. Traders also use delta as a rough estimate of the chance the option finishes in the money: a 0.30 delta call has roughly a 30% chance. Many covered call funds and option sellers describe their strikes by delta, such as “selling 0.25 delta calls.”