Option Pricing Part 1

The premium of an option can be divided into two parts
1. Intrinsic Value
2. Time Value

The Intrinsic Value is the different between the strike price of an option and the market price of the underlying securities. For example if HSBC OCT 09 $85 Call options are trading at a premium of $5.5 and HSBC shares are trading at $89 per share, the option has an intrinsic value of $4.0. This is because the option taker has the right to buy HSBC at $85 per share which is $4 lower than the market price. Option that has intrinsic value are said to be “In-The-Money” (ITM). When the share price equals the strike price, the call and put option are said to be “At-The-Money” (ATM). And if the HSBC was trading at $84, there will be no intrinsic value with the above option. So if the share price is less than the strike price of the call option, the option is said to be Out-Of-The-Money (OTM).

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