An option premium is the fee that the buyer of an option contract pays for the right to buy or sell stocks or other securities at a pre-set price when the contract’s time limit expires. From the perspective of the option seller, the premium is the fee received in exchange for the obligation to buy or sell the designated security at the designated price if the option holder exercises the right. Intrinsic value and time value are the main influences on the amount of the premium.
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Option premiums are assessed per share. Since option contracts are for 100 shares, the amount of the option premium is multiplied by 100 to arrive at the cost of the option. So an option premium of $0.50 per share would be $50 when multiplied by 100 shares. The option premium is a non-refundable, up-front fee that the option buyer pays to the option seller when the contract is purchased.
Understanding Premium Pricing
The premium price is primarily determined by the intrinsic and time value of the option. The market volatility of the underlying asset is also a factor in setting the price. The intrinsic value is the difference between the current price of the security and the strike price. For instance, if a call option is purchased with a strike price of $40 on a security currently trading at $50, the intrinsic value of the premium is $50 minus $40 or $10. Only options that are in the money have intrinsic value. Out-of-the-money options have no intrinsic value.
The time value, also called the extrinsic value, is determined by the amount of time until the option expires. The longer the period of time until the option expires, the more the time value will increase the value and amount of the premium. An option with an expiry date that is a year away will have a greater time value than one that expires in 90 days.
To see what the time value of a premium is, subtract the intrinsic value from the premium. That is, if the premium is $80 and the intrinsic value is $60, then the time value is $80 minus $60 or $20. As the date when the contract expires comes closer, the time value gets lower. On the date that the contract expires, the time value goes to zero.
The volatility of the underlying security is also a factor in setting the premium. When the price of the underlying security fluctuates more, the more impact volatility will have on the premium. More volatility means a higher premium. Some other factors that can influence option premiums include fundamental quality of the underlying security, overall market conditions and interest rates.
Using Option Premiums
Option buyers can use an understanding of option premiums to decide whether a given option has an attractive price. For instance, if the option anticipates that the volatility of the underlying security will increase significantly during the option’s term, that may mean the option is attractive based on the current premium.
Option sellers use option premiums to hedge their positions. The money received from selling options can help reduce the impact of a negative event such as a decline in the prices of the securities in their portfolios. The fees can also help improve returns from the stocks they own.
Bottom Line
Options premiums are fees charged to buyers of option contracts. The premium gives the buyer of the option the right to buy or sell a specific security at a fixed price when the contract expires. The premium goes to the seller of the option, who is then obliged to sell or buy the designated security at the designated price if the buyer chooses to exercise the option. Premium prices are quoted per share and paid in advance.
Tips for Investing
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