As mentioned in “
Option Price Components”, option price or premium consists of:
For ITM Option:
Option Price = Intrinsic Value + Time Value
For ATM and OTM Options:Option Price = Time Value
Whereas:
Intrinsic Value of ITM CALL Option:Intrinsic Value = Current Stock Price – Strike Price.
Intrinsic Value of ITM PUT Option:Intrinsic Value = Strike Price – Current Stock Price.
As you can see from the above formula, Intrinsic Value of an option is very straightforward.
It’s simply the difference between option’s strike price and current stock price.
Time Value component of an option is the one that make an option very complicated to understand.
Time Value of an option would be
mainly affected by:
1) Degree of Options Moneyness
As discussed in
this post, Options Moneyness describes the relationship between an option’s Strike Price with stock price (i.e. where the Option’s Strike Price is in relation to the current stock price).
The farther the option’s Strike Price to current stock price, the lower the time value will be.
Therefore, since for ATM options, the option’s Strike Price is the same as the current stock price, ATM options would consequently have the highest time value.
The time value will gradually decline as it moves to deeper ITM and deeper OTM options (like inverted-U curve), because the deeper ITM or OTM an option, the farther its Strike Price from the current stock price.
2) Implied Volatility (IV)The higher the IV, the higher the option’s time value.
3) Time Remaining to ExpirationThe longer the time remaining to expiration, the higher the option’s time value.
All other things being equal, an option with more days to expiration will have more time value than an option with fewer days to expiration.
Hence, Implied Volatility (IV) is not the only one that influences an option’s time value. That’s why although, for instance, IV of an option is very much higher than the other options, it does not mean that its premium will be higher in terms of dollar value. There are other factors affecting their overall premium.
Just remember that whether an option is considered “cheap” or “expensive”, it is
not based on the absolute dollar value of the option, but instead based on its IV.
When the IV is relatively high, that means the option is considered “expensive”.
On the other hand, when the IV is relatively low, the option is considered “cheap”.
(Please see this post –
How To Determine If An Option Is Cheap (Underpriced) Or Expensive (Overpriced) – for further discussion).
However, the overall option price / premium in absolute dollar value will be determined by other factors as discussed above.
Therefore, it’s possible that an option is low in terms of dollar value, but it’s considered “expensive” due to relatively high IV.
On the other hand, an option can be high in terms of dollar value, but it’s considered “cheap” due to relatively low IV.
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