Answer to Question #163453 in Economics for ackelia mclaren

Question

Why do options sell at prices higher than their exercise values?

Answer 1

In the world of options, there is a certain benchmark that determines the current price of an option, which will be neutral (do not bring any profit or loss under the current market parameters) for both the seller and the buyer. This benchmark is calculated using one of several formulas. The most famous and used is the Black-Scholes formula.

According to this formula, the option price is a function of the following parameters:

Current price of the underlying asset

Strike price

Risk-free interest rate

Time to expiration of the option

The volatility of the return on the underlying asset.

Cumulative distribution function of the standard normal distribution.

The option price for a particular strike generally consists of the sum of two components:

The income that we receive when the option expires on this strike (blue bar) - otherwise it is called the intrinsic value of the option.

The premium that the seller of the option receives for taking the risk (red bar) - otherwise called the time value of the option. Roughly speaking, this is the geometric difference between the red and blue lines.

The main parameter influencing the time value is the probability of whether the option will be exercised at expiration or not. In this case, the greater the probability that the option will not be exercised (will be "out of the money") or vice versa will be exercised (will be "in the money"), the lower its time value.