13 Nov 2026
How Is Option Premium Priced?
Option premium, the price a buyer pays and a seller receives for an option, is determined mainly by six inputs: the underlying asset’s price, the strike price, the time until expiration, expected volatility, interest rates and expected dividends. Premium has two parts, intrinsic value, which is what the option would be worth if exercised now, and time value, which reflects the chance of a more favorable outcome before expiration. For option income funds, understanding these inputs explains why the premium they collect changes from week to week.
What are intrinsic value and time value?
Intrinsic value is the amount by which an option is in the money. A call with a strike of 95 on an index at 100 has 5 points of intrinsic value. A call with a strike of 105 has none.
Time value is everything else in the premium. It reflects the possibility that the option gains value before expiration. Time value is highest for at-the-money options and shrinks as expiration approaches, reaching zero at expiration.
Option sellers in income strategies typically sell at-the-money or out-of-the-money options, so most of the premium they collect is time value.
What are the six inputs?
Underlying price. As the underlying rises, call premiums generally rise and put premiums fall.
Strike price. Calls with lower strikes and puts with higher strikes cost more because they are closer to, or deeper in, the money.
Time to expiration. More time generally means more premium, though not proportionally. Time value tends to grow with the square root of time, so a one-month option is worth roughly twice a one-week option at the same strike, not four times.
Volatility. Higher expected volatility raises both call and put premiums, because large moves make favorable outcomes more likely. Volatility is the only input not directly observable; the market’s estimate is called implied volatility. Our article on implied volatility and option income explores it in detail.
Interest rates. Higher rates slightly raise call premiums and lower put premiums, reflecting the cost of carrying the underlying asset.
Dividends. Expected dividends lower call premiums and raise put premiums, because dividends reduce the underlying’s price when paid.
How do pricing models work?
In 1973, Fischer Black and Myron Scholes published a model for pricing options, extended by Robert Merton, that combined these inputs into a formula.1 The Black-Scholes model and its successors remain the foundation of option pricing, although traders adjust for features the original model did not capture, such as different implied volatilities at different strikes. In practice, market prices come from supply and demand, and implied volatility is backed out of those prices.
What are the Greeks?
Traders use a set of measures, called the Greeks,2 to describe how premium responds to each input:
Delta measures how much the option price changes for a one-point move in the underlying. At-the-money options have a delta near 0.50.
Theta measures how much value an option loses each day as time passes, all else equal. Option sellers benefit from theta.
Vega measures how much the price changes for a one-point change in implied volatility. Option sellers lose when implied volatility rises, all else equal.
Gamma measures how quickly delta changes as the underlying moves. Short-dated at-the-money options have high gamma, meaning their sensitivity to price moves can shift rapidly.
What does an example look like?
Consider an index at 100 with implied volatility of 20%. A common approximation for an at-the-money option’s premium is 0.4 times volatility times the square root of time. (Hypothetical approximation, before fees and expenses, ignoring interest rates and dividends.)3
One-week option: 0.4 × 20% × √(1/52), or about 1.1% of the index.
One-month option: 0.4 × 20% × √(1/12), or about 2.3%.
Three-month option: 0.4 × 20% × √(1/4), or about 4.0%.
Selling a one-week option every week would collect more total premium over a month than selling one monthly option, but it would also reset the strike more often, which changes how much upside is given up and how the strategy behaves in fast-moving markets. Our article on weekly and 0DTE option income ETFs discusses those trade-offs.
How does skew affect premium?
Implied volatility is not the same at every strike. For stock indexes, puts with strikes below the current level usually carry higher implied volatility than calls with strikes the same distance above it. This pattern, called skew, means a covered call fund selling out-of-the-money calls may collect less premium than a simple model assuming one volatility level would suggest, while a put-write fund selling out-of-the-money puts may collect more.
What is put-call parity?
Put-call parity is a relationship linking the prices of puts and calls with the same strike and expiration to the underlying price and interest rates. It implies that owning an index and selling a call produces a payoff similar to holding cash and selling a put with the same strike. That is why covered call and put-write strategies on the same index tend to behave similarly. Our article on what is a put-write ETF explains the connection.
Frequently asked questions
Why do option premiums change every day?
Premiums respond continuously to changes in their inputs. As the underlying price moves, as expiration approaches and as implied volatility rises or falls, the fair value of each option shifts. Interest rate and dividend expectations change less often but also matter. Supply and demand for particular options can also move prices, especially around events such as earnings or economic releases.
What is time decay?
Time decay is the decline in an option’s time value as expiration approaches, measured by theta. All else equal, an option loses value each day because there is less time for a favorable move. Decay tends to accelerate in the final days before expiration, especially for at-the-money options. Option sellers benefit from time decay, while buyers lose from it.
Why is volatility so important in pricing?
Volatility determines how likely large moves are. Since an option’s payoff is asymmetric, buyers gain from large moves in one direction while their loss is limited to the premium, so greater expected volatility makes options more valuable. Because future volatility is unknown, the market’s estimate, implied volatility, is often the input that changes premiums most from day to day.
Are puts and calls priced the same way?
They use the same inputs and models, and put-call parity links their prices at the same strike and expiration. But for stock indexes, out-of-the-money puts often carry higher implied volatility than equally distant calls, reflecting demand for downside hedges. This pattern, called skew, means puts and calls at different strikes can price differently relative to a single volatility assumption.
Do option income funds use pricing models?
Funds that sell options use pricing models and market data to choose strikes and expirations, evaluate premium levels and monitor risks. They generally sell options at market prices on exchanges or in negotiated trades rather than at model values. The models help managers understand how premium and risk are likely to change as markets move.
How does option pricing affect a fund’s income?
The premium a fund collects depends on the options it sells and on market conditions at the time. Higher implied volatility, longer expirations and strikes closer to the current price generally produce more premium. Lower volatility or more distant strikes produce less. Changes in these factors help explain why option income funds’ distributions can vary over time.
- Fischer Black and Myron Scholes, “The Pricing of Options and Corporate Liabilities,” Journal of Political Economy, 1973; Robert C. Merton, “Theory of Rational Option Pricing,” Bell Journal of Economics and Management Science, 1973.
- Options Clearing Corporation, “Characteristics and Risks of Standardized Options.”
- Calculations are VistaShares illustrations using a standard approximation for at-the-money option prices.
Cite this page: Adam Patti, "How Is Option Premium Priced?," VistaShares, updated November 13, 2026, https://www.vistashares.com/how-option-premium-is-priced/. Plain-text version.
This material is provided for educational purposes only. It is not investment, legal or tax advice, and it is not a recommendation or an offer to buy or sell any security. Information is drawn from sources believed to be reliable as of the date of publication, is not guaranteed as to accuracy or completeness, and may change without notice. Figures attributed to third parties are their estimates. Projections and forecasts are not guarantees of future results. Investors should consult their own financial, legal and tax professionals before making investment decisions. Investments involve risk, including possible loss of principal. Strategies that use options involve additional risks, including limited participation in market gains, the risk that options do not perform as intended, and changes in distributions. Tax treatment depends on individual circumstances and on current law, which may change.