**Pricing Options**

An option price is composed of two components. One is intrinsic value the other is time value.

**Intrinsic Value:**

Only in the money options have intrinsic value. For a call option intrinsic value is the difference between current market price and strike price.

If the difference is positive (currenct market price > strike price) then intrinsic value is the absolute value of the difference.

If difference is negative (currenct market price < strike price) this means that the call option is out of the money and intrinsic value is zero. For a put option intrinsic value is the difference between strike price and current market price. If the difference is positive (strike price > current market price) then intrinsic value is the absolute value of the difference.

If difference is negative (strike price < currenct market price) this means that the put option is out of the money and intrinsic value is zero.

**Time Value:**

Time value is the value of an option arising from the time left to maturity. This definition can also be expressed as the amount an investor is willing to pay for an option above its intrinsic value with the expectation that at some time prior to expiration its value will increase bacause of a favorable market move. If time to expiry of an option is more than time value of the option will be greater. The parameters that affect.the option price is, Spot Price, Strike Price, Time Until Expiration, Volatility, Interest rates and Dividends. Spot Price, Strike Price, Time to expiration and interest rates or dividends affect the moneyness of the option. Moneyness affect both the intrinsic and time value of the option.

On the other hand Time to expiration and volatility affects the time value of option. Black & Scholes model uses all of these inputs and calculates the option premium mathematicaly on some assumptions. Although the model has many drawbacks it widely used in the options market for pricing the options because of its robustness and simplicity.

The modelâ€™s most advantage is, it can be used to solve for volatility, which gives the implied volatility of an option at given prices, durations and exercise prices. Solving for volatility over a given set of durations and strike prices one can construct an implied volatility surface.

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