Part V · Options · Chapter 5B

What an option's price is made of

Premium and the option chain

1 · Two parts of a premium

An option's premium is the sum of two distinct components: intrinsic value, what the option would be worth if exercised this instant, and extrinsic value, also called time value, which is everything else. Extrinsic value is the market's price for the remaining uncertainty and time. The decomposition is exact, and the intuition behind it is foundational:

Intrinsic value is the payoff of Chapter 5A with today's price $S$ in place of the price at expiry:

Take a call with a strike of $100 and the stock at $103. Exercising it would let you buy at $100 and sell at once at $103, capturing $3 a share, so the intrinsic value is exactly $3. With the stock at $97 instead, exercising would mean paying $100 for something worth $97. Rational holders do not exercise at a loss, so the intrinsic value is zero.

Extrinsic value is whatever the premium holds beyond the intrinsic value:

It captures the time remaining, the market's expectation of volatility, and the chance of a favorable move before expiry. For an option that can be exercised at once, extrinsic value is never negative, since exercising would always capture the intrinsic value. A deep in-the-money European put can trade slightly below its intrinsic value, because its holder must wait until expiry to receive the strike, and waiting costs interest.

How the premium divides between the two parts depends on moneyness, the position of the strike relative to spot:

• Deep in-the-money (ITM) options, with spot well above the strike for a call or well below it for a put, have a small extrinsic part. Such an option is almost all intrinsic and behaves like a delta-1 position in the underlying (Chapter 5C).
• Out-of-the-money (OTM) options have no intrinsic part, so all their value is extrinsic, resting on the possibility of a favorable move. The further out of the money, the higher the extrinsic value relative to the intrinsic. A deep OTM option is a pure bet on a tail move.
• At-the-money (ATM) options have the maximum extrinsic value, because they carry the maximum uncertainty about whether they finish in or out of the money.

The figure below splits a call and a put, both struck at K = 100, into their two parts. It holds the total premium at $6.50 for illustration, so that you can watch the split on its own. Drag spot S from 85 to 115. It starts at 105, where the call holds $5 of intrinsic and $1.50 of extrinsic value while the put is all extrinsic.

spot S

$105.0

K = 100	Intrinsic	Extrinsic	Total
Call	$5.00	$1.50	$6.50
Put	$0.00	$6.50	$6.50

As spot crosses the strike, intrinsic value passes from one option to the other: the put's shrinks as the call's grows, the mirror image the caption describes. Once an option is more than $6.50 in the money, the figure's premium is all intrinsic. A real premium does not stay fixed as spot moves, however: a call's premium rises with spot, at a rate Chapter 5C calls delta. The coin-flip example shows the real pattern of extrinsic value, which peaks at the strike.

2 · The option chain

The option chain is the central interface for options trading: calls on the left, puts on the right, and strikes down the middle, with each row one strike at the chosen expiry. The critical columns are the bid, the ask, the volume and the open interest, not the "last" price, which can be stale and misleading.

Here is a synthetic chain for a stock at $150 with 32 days to expiry (DTE). Its prices come from the Black-Scholes model of Chapter 5C at a single implied volatility of about 14%, with interest ignored, so that they obey put-call parity (Chapter 5F).

The 140-strike call is deep in the money, with $10 of intrinsic value, so its premium near $10.13 is almost all intrinsic. The small extrinsic part, 13 cents, remains because at 32 DTE there is still some uncertainty. The 140-strike put is deep out of the money, so its premium is near zero. The 150-strike call and put, at the money, are nearly identical in price ($2.45 to $2.55) because put-call parity (Chapter 5F) ties them together. The deep out-of-the-money 160-strike call has a near-zero premium because a 7% move in 32 days is unlikely.

Subtract each option's intrinsic value from its mid-quote and the coin-flip pattern appears. The extrinsic value runs $0.13, $0.73, $1.61, $2.50, $1.64, $0.79 and $0.17 from the 140 strike to the 160, peaking at the money. A call and a put at the same strike carry the same extrinsic value here, which is put-call parity at work in a chain without interest.

What each column means

• Bid and ask: the highest price a buyer is offering right now, and the lowest price a seller is asking. The bid-ask spread between them is your immediate execution cost. SPY options often have $0.01 spreads on liquid ATM strikes, SPX can have $0.10 to $0.30, and XSP sits somewhere in between. Always use limit orders on options, which name the worst price you accept, and never market orders, which accept whatever price is there.
• Last: the price of the most recent trade, which can be hours or even days old in an illiquid strike. Treat it as history rather than as a price you can act on, and read the bid and the ask instead.
• Volume: the number of contracts traded today, a measure of current interest that resets at the start of each trading session.
• Open interest (OI): the total number of contracts at this strike that have been opened but not yet closed or expired. Open interest is the single best liquidity indicator. High open interest means a deep market with narrow spreads. Low open interest means wide spreads, potential slippage and, in the worst case, a strike where you cannot exit at any reasonable price.
• ITM shading: most brokerage platforms shade the in-the-money rows. Calls are in the money below spot (strike below spot) and puts above it (strike above spot), so the shading flips at the at-the-money row. In the chain above, the calls from 140 to 148 and the puts from 152 to 160 would be shaded.

Every trade has a buyer and a seller, and each of them is either opening a position or closing one. That decides how the trade moves open interest:

3 · The bid-ask trap

Two options can look identically priced, both showing $3.00 as the last trade, and still cost very different amounts to trade. Suppose the first is quoted $2.95 bid, $3.05 ask and the second $2.50 bid, $3.50 ask. Both have a mid-quote, the average of bid and ask, of $3.00, but the second is dramatically more expensive to trade.

You either lift the ask at $3.50, paying $0.50 over the midpoint, or sit on the bid at $2.50 and possibly never fill. That $0.50 of extra cost is $0.50/3.00 = 16.7\%$ of the option's value, which is the entire variance risk premium edge you would expect to harvest. Two trades at this spread, one to enter and one to exit, can wipe out three months of theta collection (theta is the daily decay of Chapter 5C).

Measure every spread as a share of the mid:

For the tight quote, (5B.4) gives $0.10/3.00 = 3.3\%$. A round trip, buying at the ask and later selling at the bid, costs the full $0.10, or $10 a contract. The wide quote gives $1.00/3.00 = 33\%$, with a round trip costing $100 a contract, ten times as much for an option of the same value. The tight quote passes a 5% limit but not a 2% one, while the wide quote fails both by a long way.

Bid-ask discipline is not a detail: it is the floor under everything else. The recommended retail discipline is never to trade an option unless its bid-ask spread is less than 5% of the midpoint, and ideally less than 2%. For ATM SPY options this is trivially met. For deep out-of-the-money, low-OI single-name options it often is not, and the right response is to not trade that option.

A related practice is mid-price filling: most professional options strategies enter at the bid-ask midpoint or better, using limit orders that work the midpoint rather than crossing the spread. If you place a limit order at the midpoint and the market does not fill you, the trade probably was not worth doing at the price you wanted. Patience is the cost of getting better fills. Impatience is the cost of paying the full spread on every trade.

4 · Open interest through expiry

Open interest changes daily as contracts open and close. For most strikes it rises through the early life of the contract as positions are built, then falls in the final week as positions are closed before expiry. The 0DTE phenomenon in SPX has changed this dramatically: for a 0DTE strike, open interest is functionally zero, since the strike did not exist yesterday, and volume tells the whole story.

Watching open interest change can be informative, as when open interest at one strike jumps by 50,000 contracts on a day when volume there was also 50,000 contracts. By the table above, every contract that traded opened a new position on both sides, which tells you a single large player took a new position at that strike. Smaller and more frequent changes in open interest suggest broader market activity.

For dealer mechanics (Part VIII), aggregate open interest across all strikes is the input to the gamma exposure (GEX) calculation of Chapter 8A. The shape of open interest across strikes determines the gamma flip level (Chapter 8C) and the regime characterization of Chapter 8D.

5 · Check yourself