What Is an Option Premium?

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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Understanding Premium Pricing

Businesswoman checking her options contracts.

Option premiums are a critical concept in options trading, reflecting the cost associated with buying or selling an option contract. These premiums are assessed per share, and since option contracts typically cover 100 shares, the premium amount is multiplied by 100 to calculate the total cost. For example, an option premium of $0.50 per share results in a total cost of $50 ($0.50 x 100 shares).

The option premium is a non-refundable, up-front fee that the buyer pays to the seller at the time of purchase. It is influenced by several factors, including intrinsic value, time value and market volatility.

1. Intrinsic Value

The intrinsic value reflects the difference between the current price of the underlying asset and the option’s strike price. This value is only present in options that are “in the money.”

Call Option Example: If a call option has a strike price of $40 and the underlying asset is trading at $50, the intrinsic value is $10 ($50 – $40).
Put Option Example: If a put option has a strike price of $60 and the underlying asset is trading at $50, the intrinsic value is $10 ($60 – $50).
Options that are “out of the money” have no intrinsic value.

2. Time Value

The time value, or extrinsic value, is determined by the amount of time left until the option expires. The longer the time until expiration, the higher the time value of the premium.

Calculation: Subtract the intrinsic value from the premium to find the time value. For example, if the premium is $80 and the intrinsic value is $60, the time value is $20 ($80 – $60).
Key Point: As the expiration date approaches, the time value diminishes, reaching zero on the expiration date. This is known as “time decay.”

3. Market Volatility

The volatility of the underlying asset significantly impacts the option premium.

Lower volatility reduces this likelihood, resulting in a lower premium.
Higher volatility increases the likelihood of price swings, making the option more valuable.

Additional Factors Influencing Option Premiums

Several additional factors can influence the price of an option premium. The fundamental strength of the underlying asset plays a significant role, as securities with stable earnings or a strong market position typically exhibit lower volatility, resulting in lower premiums.

Overall market conditions also affect premiums, with broad market trends and investor sentiment driving fluctuations in pricing. Furthermore, interest rates can impact option premiums, particularly for longer-term contracts. Changes in interest rates affect the cost of holding positions, which is factored into the pricing of options.

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.

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Tips for Investing

Options trading can be an effective way to hedge a portfolio and increase returns, but it is for sophisticated investors. An experienced and qualified financial advisor can help an investor understand whether an option premium reasonable and how to use options in investing. Finding such an advisor isn’t difficult. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
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