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How Are Options Prices Determined?

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 worthâ€Šâ€”â€Šin 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 â€˜greeksâ€™).

These time and volatility values are not directly calculatedâ€Šâ€”â€Šbut 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.

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 normalâ€Šâ€”â€Šleading to increased **price premiums**.

Last modified 7mo ago

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