You’ve met the premium — the price of an option. But why is it that price, and why does it change? Premium is made of two pieces.
Intrinsic + extrinsic value
Premium = intrinsic value + extrinsic value
- Intrinsic value is how much the option is already worth if exercised now. For a call, that’s
price − strike(never below zero); for a put,strike − price. - Extrinsic value is everything else — the price of possibility. It comes from the time left and how much the stock might move.
A $100 stock, a $95 call trading at $7: intrinsic value is $5 (100 − 95), so the other $2 is extrinsic.
The three big levers
- Price of the underlying. The most obvious one. As the stock rises, calls gain and puts lose (and vice versa).
- Time to expiry. More time = more chance to move = more extrinsic value. As expiry nears, that value bleeds away (you’ll meet this as time decay soon).
- Volatility. The big one beginners miss. If the market expects bigger swings, options get more expensive — even if the price hasn’t moved at all.
Implied volatility (IV)
Implied volatility is the market’s guess at how much the stock will move, baked into the premium. High IV → fat premiums; low IV → cheap ones.
This is why you can buy a call, be right about the direction, and still lose money — if IV fell while you held it (a “volatility crush”, common right after earnings).
Why it matters
Most beginners think only about direction. But you’re really trading direction, time, and volatility at once. Keep all three in mind and the payoff playground will start to make a lot more sense.