Option Premium

An option premium is a fee a trader pays for a call or put option contract. When an individual buys an option contract, they get the right to buy or sell the underlying financial instrument, for example, a stock at a particular price before or on the contract's expiration date.

The main components of this premium are the time value, intrinsic value, and the underlying security's implied volatility. For example, when an option moves closer to its expiration date, its time value nears $0. On the other hand, the intrinsic value closely represents the difference between the contract's strike price and the underlying financial instrument's price.

• Option premium meaning refers to the fee that an option buyer pays a seller to get the right to purchase or sell an option at a preset price within a particular duration. Simply put, it is the current market price of an option contract.
• Individuals must compute the sum of an option contract's intrinsic value, extrinsic value, and the underlying financial asset's volatility value to calculate the option premium.
• A noteworthy difference between this premium and strike price is that the former is a fixed dollar amount while the latter is not.
• Option sellers use the premium to hedge positions.

Option premium meaning refers to the price that an option buyer pays for the right to buy or sell an underlying financial instrument at a predetermined price within a specific period. At the same time, it is the fee received by an option writer in exchange for the obligation to buy or sell an option contract if the option holder decides to exercise the right.

Option buyers can utilize their understanding of this premium to determine if an option contract's price is appealing. For example, if traders think that the underlying asset's volatility will increase significantly during the contract's term, they might deem the option attractive based on its current premium.

Option writers utilize this premium to hedge their positions. In other words, the gains earned from selling options contracts can help them mitigate the impact of an adverse event, for example, a fall in the price of the financial instruments in their portfolio. Moreover, this premium can help increase the returns from their investments.

There are three main factors affecting put or call option premiums. Let us look at them in detail.

#1 - Intrinsic Value 

The intrinsic value would be the option contract's value if one exercised immediately. As noted above, in simple terms, an option's intrinsic value is the difference between the underlying financial asset's price and the option's strike price. In the case of call options, one can compute intrinsic value by subtracting the contract's strike price from the underlying asset's market price. That said, the opposite is true for put options. This means that one can compute the intrinsic value for put options by subtracting the underlying financial instrument's market price from the strike price.

One considers an option in the money if it has intrinsic value. In this case, the premium includes the intrinsic value. On the other hand, if an option contract does not have intrinsic value, it is out of money. In this case, the contract's premium is based on the underlying asset's volatility and the time value. The combination of these two factors determines how likely the options contract will become in the money by expiration.

#2 - Time Value

An options contract's time or extrinsic value depends on the time remaining until expiration. The longer an option contract has until expiry, the higher the extrinsic value. An option contract has a higher premium the farther it is from its expiration date, keeping other aspects aside. One must also remember that an option contract's time value drops faster as it approaches the expiration date. In other words, the extrinsic value decreases exponentially instead of linearly. One can calculate the extrinsic value by computing the difference between the intrinsic value and the premium.

#3 - Volatility Of The Underlying Financial Instrument

Volatility is the degree to which the underlying financial instrument's price varies regularly; one can measure it using the concept of standard deviation. Individuals must remember that the higher the volatility, the higher the put or call option premium.

The option premium formula is as follows:

Option Premium = Intrinsic Value + Time Value + Volatility Value

Let us look at this option premium example to understand the concept better.

Suppose XYZ stock's call option has an intrinsic value of $5 and a time value of $40. Moreover, the stock's volatility value is $1.5.

One can use the above formula to calculate option premiums.

Therefore, the premium will be:

$46.5 ($5 + $40 + $1.5)

The calculation can be explained with the help of a diagrammatic representation as given below. The given diagram clearly shows that the premium at the beginning is purely dependent on the time value. As the contract progresses towards expiry, the premium amount depends on the time and intrinsic value of the contract, which is the difference between the strike price and the price of the underlying asset. But at the expiry, the premium is totally dependent on the intrinsic value. This is because there is no time left for the contract since it has reached its expiry. However, the volatility of the underlying asset also influences the premium amount. If the prices fluctuate too much, this will lead to a rise in the premium amount as the risk is high. The opposite will happen in the case of an asset with stable market conditions.

Source

The terms, option premium, and strike price can confuse individuals new to derivatives trading. That said, they must understand the differences between these two concepts before starting to trade. Hence, the table below highlights the distinct characteristics to help one understand the differences.

This article has been a guide to what Is Option Premium. Here, we explain its formula, calculation, and an example and compare it with the strike price. You may also find some useful articles here -

• Put Option
• Ladder Option
• Option Pricing