What is an Option Premium?
How are option prices determined?
What are the essential elements you should know!
In this article, we will break down the definition of Option Premium so you know all there is to know about it!
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What Is An Option Premium
An option premium is the market price that a trader or investor will need to pay to purchase an option contract.
In other words, the “premium” on the options represents the amount of money paid by the option buyer to the option seller for an option contract.
Typically, options for stocks as underlying security are quoted in dollars per share and every option contract is generally for 100 shares.
For example, if the option price for a particular stock is $2 per share, an investor will need to pay $200 to purchase an option contract for 100 shares.
Option prices quoted on an options exchange are considered to be the premium an investor will be required to pay to purchase the options.
Option Premium Definition
According to Investopedia, an option premium is defined as follows:
An option premium is the current market price of an option contract.
This financial definition is quite clear and simple.
The option “premium” is equal to the option “market price” or “market value”.
What Affects Call And Put Option Premium
There are several factors that affect option premiums in general:
- The value of the underlying asset or stock
- The moneyness of the options
- The time left to the expiration of the option contract
- The implied volatility of the underlying security
Value of Underlying Security
The value of the underlying security or stock has a direct impact on the value of the option premium.
For example, if the underlying stock goes up, the premium on the call options related to that stock will go up whereas the premium for put options on the same stock will go down.
The second aspect relating to the moneyness of the options will also have an impact on the premium an investor will be ready to pay to purchase an option contract.
Moneyness of Options Contract
The “moneyness” refers to how far is the underlying stock price from the option strike price.
For example, if the stock price is $25 and the strike price of a call option is $30, it is close to the money.
On the other hand, if the underlying stock trades for $10, it’s much farther to the strike price of $30 and the option contract will be less desirable (therefore lower premiums expected).
The more the options are in-the-money, the more investors will pay a higher premium to purchase the options.
The opposite is also true.
The more the options are out-of-the-money, the less investors will pay a high premium for the options.
The useful life of the options will have a direct impact on the value of the premium.
The more you have time to exercise your options, the more the options contract will be valuable to a trader.
The less you have time to exercise the options, the less an investor will be prepared to pay for the options.
The closer you get to the expiration date, the value of the premiums will be driven by the intrinsic value of the options as opposed to its extrinsic value.
Another factor having an impact on the price of options is the implied volatility of the underlying asset.
“Implied volatility” refers to the underlying stock’s potential to fluctuate in price.
The more the underlying stock is volatile, the more the option on the same stock will be worth more as there’s a possibility for the stock to fluctuate to a point where the option goes into the money.
The less a stock is volatile, the less the option on the same stock will be valuable to a trader as there’s less chances that the stock price will move into a profitable range.
Intrinsic And Extrinsic Value of Options
The value of the option is based on its intrinsic and extrinsic value.
Options that are “in-the-money”, the value of the premium is composed of:
- The intrinsic value of the options contract
- The extrinsic value of the options contract
On the other hand, when the options are “out-of-the-money”, their value is strictly determined by the extrinsic value of the options.
The intrinsic value represents the difference between the option’s strike price and the value of the stock.
For example, a call option with a strike price of $30 will have an intrinsic value if the underlying stock trades above $30.
This means that the option holder may earn a profit by exercising the option.
There are certain factors that can also affect the value of call option premiums and put option premiums, namely:
- The time left before the options expire
- The volatility of the underlying stock price
An option contract with longer time left before its expiration will be worth more than options that are about to expire.
As you near the option expiration date, the value of the options contract moves towards zero.
Option Premium Examples
Let’s look at a few examples to better understand the “option premium” concept.
Let’s assume that Apple Inc stocks trade for $500 per share.
If an investor wants to buy options on Apple stocks, the premium he or she will be ready to pay will depend on:
- The intrinsic value
- The time value
- Implied volatility
The intrinsic value is the difference between the options strike price and the Apple stock price.
If you are looking at a call option with a strike price of $450, then the options are “in-the-money” and will have an intrinsic value as you can buy the options and exercise them immediately to earn a $50 profit per share.
On the other hand, if the options have a strike price of $600, the options are out-of-the-money and the option premium will not have any intrinsic value but an extrinsic value.
Now imagine your Apple options contract is expected to expire in three weeks.
This means that you have up to three weeks to be able to exercise your options and the stock price can fluctuate into the money range.
This is worth more than if the options are expected to expire tomorrow as you only have one day to get into the money.
Finally, the implied volatility of the Apple stock will have an impact on the option premium you’d pay.
If the Apple stocks tend to fluctuate a lot, it will have a high implied volatility and will result in the option premiums to be higher.
If the stock has a lower implied volatility, and less swings in the market price, then the options will also be less expensive to purchase.
Options Premium Takeaways
So, what is the option premium?
What is a premium in options (with example)?
Let’s look at a summary of our findings.
Option Premium Meaning And Premium Price Determination
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