Unit 2 · Level 4 · Options I
Premium anatomy
Premium = INTRINSIC value + EXTRINSIC value. Intrinsic: the profit if exercised right now (market vs strike). Extrinsic: everything else, the price of TIME remaining and expected VOLATILITY. An option with zero intrinsic value can still cost plenty, because time and possibility have a price.
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What you get asked
Stock at $105. A $100-strike call trades at $8. Split the premium:
The $5 is real profit-if-exercised-now; the $3 is the market charging for what MIGHT still happen before expiry.
Match the moneyness term to its state (for a call)
Puts mirror the logic. OTM options are 100% extrinsic: pure time-and-possibility, which is exactly what melts.
Why does an option lose value every day even if the stock doesn't move?
Extrinsic value is an ice cube; expiry is the sun. Decay accelerates as expiry nears; the last weeks melt fastest. Buyers fight the clock; sellers befriend it.
Higher expected volatility makes ALL premiums ___, because possibility itself gets more expensive.
A wild stock might reach any strike, so its options cost more (higher 'implied volatility'). This is why premiums balloon before earnings: the market pre-prices the coming jump.
The classic beginner burn: buying calls right BEFORE earnings, stock jumps 5%… and the call barely gains or LOSES. What happened?
You paid a pre-event premium inflated by anticipation; after the event, anticipation deflated. Being right about direction and STILL losing. Options add a second dimension (volatility) to every bet. Respect it. 🐜
The rest of this unit
Calls, puts, premium anatomy, delta & theta: risk as a design input.