How do the Parameters of an Options Contract Determine Its Value? How do I Know It’s a Fair Deal? How is the Price Premium Determined?
It is difficult to precisely determine how different parameters determine the contract’s value because the market is P2P bid /ask. but here are some general guidelines on how prices work:
You have two pricing mechanisms, the intrinsic and extrinsic value.
The intrinsic value is determined simply by the difference between the current price and the strike price. If an ETH/USDC call has a strike of $1400 and the current price of ETH is $1500, then the call has an extrinsic value of $100 (1500 - 1400) because you could immediately purchase the call and exercise it to receive $100.
The extrinsic value, determined by the market condition, has a few factors:
- Time Value of the option — the farther the expiration date is, the more time value.
- Volatility of the underlying asset — as the more volatile the currency pair, the more chance it could go up or down in price, resulting in a higher intrinsic value (sidenote: this is where the “greeks” people talk about are generated).
So the actual observed price of an option like a call or put is intrinsic value + extrinsic value. It should never be less than that, or there is an arbitrage opportunity. In the upcoming versions of Hedgey, we will have analytics on defining intrinsic values to assist users in understanding fair trades.
