|If on the other hand the exercise price was a long way from the underlying asset price then it would be very clear if the option was going to be exercised or not.
In this case the seller could make a price for the option almost entirely relying on this fact and either charge close to zero (if it was not likely to be exercised) or the Intrinsic Value (if it was).
b) When the option has a long time to go before maturity
For options with very long maturities the uncertainty over whether the option will be exercised is clearly much greater.
In this case the option's value will usually have a very large element of Time Value.
c) When the price of the underlying asset is very volatile
The key factor in determining the option premium is the expected level of volatility in the price of the underlying asset.
Volatility in this sense simply means the degree to which the price moves up and down in any given time period. A high volatility asset will have a price that fluctuates much more than a low volatility asset.
The volatility of the underlying asset is clearly important in assessing the likelihood of the option being exercised. It is also the one factor that cannot be directly observed.
Option sellers therefore have to make a judgement on the expected volatility of the underlying price in order to calculate a value for any option.
In summary then the premium of any option is made up of Intrinsic Value and Time Value. The Intrinsic Value is easily observed but the Time Value depends amongst other things on the expected volatility of the underlying asset price, something that can only be estimated.
Typically, once having made an estimate for this factor, the actual premium is calculated via a computer software package using a mathematical model such as the famous Black Scholes model, to derive the price.