Truth #1: Option Prices Are Set by the Market Makers

Option market makers use a Nobel prize winning formula and fast computer technology to help them make a market in the derivatives known as options.  This formula incorporates many variables which can be boiled down into just two basic components: Intrinsic value and time value.

Intrinsic value is determined by the relationship of the option’s strike price to the underlying’s current price.  Intrinsic value moves dollar for dollar as the underlying moves.  Meaning if the underlying goes up $1, the call option’s intrinsic value will also go up $1. If the underlying falls in value, the intrinsic value of the call option falls at exactly the same rate.  Put options are the opposite.  If the underlying drops $1 in value, a put option’s intrinsic value will rise $1 and if the underlying rises in value by $1, the intrinsic value of the put option drops $1. Intrinsic value will always either be positive or zero.

The time value (not the intrinsic value) portion of an option’s price is where the market maker adjusts the price to insure they keep their probable winning percentage at 70%.  This means the market maker will inflate or deflate the price of time in response to changes in both the macro environment and conditions of the underlying equity. Time value is also a decaying asset because it loses value as time passes.  Therefore, time value both fluctuates and constantly decays as time passes and will eventually be worth zero at expiration.

If expectations are high that the underlying will increase in volatility (like around earnings), market makers raise the price of time to keep their expected winning percentage at 70%.  The converse is also true, they’ll reduce what they charge for time during periods of lower volatility.  More advanced traders and strategies make use of these factors that affect the price of time and as you gain in experience, you may find a need to learn these advanced features.  But for now, the simple approach is to understand time both fluctuates in price and decays in value with each passing day and will eventually be worth nothing on expiration.

Trading stock differs from trading with options because options have more moving parts such as expirations dates, puts versus calls, a wide variety of strategies and the impact on time value from market expectations.  The two biggest risks to those who trade option is expiration date (the option eventually expires) and time decay.  Not only does a person need to keep track of direction (up vs. down), but they must also keep an eye on all these other factors. Some have compared stock trading to the game of checkers and options trading to chess—and rightly so.

This module will help you better understand the two primary ways to open an options position: Either as a buyer (speculator), or as a seller (cash flow generator).  Time decay works against a buyer and for a seller.  You can be either (or both) an options buyer or seller depending on the strategy you choose. Understanding how options are priced helps you select the best option strategy to implement based on your probability profile, your forecast, and your system.