What Is an Option Premium?
Let me break this down for you: an option premium is simply the price you pay as the buyer of an options contract to the seller, and it reflects the current market value of that contract.
When you buy an option, you're essentially paying for the right to buy or sell an underlying asset at a predetermined price in the future. This premium is the income the seller, or writer, receives from you. For in-the-money options, the premium breaks down into intrinsic value and extrinsic value, while out-of-the-money options are purely extrinsic value. Remember, stock options premiums are quoted per share, and most contracts cover 100 shares.
Key Takeaways
- The premium is the market price of the option.
- Out-of-the-money options have only extrinsic or time value, while in-the-money ones have both intrinsic and extrinsic value.
- Premiums tend to be higher with more time until expiration or greater implied volatility.
Understanding Option Premium
If you're writing calls or puts—meaning you're selling them—you can use these premiums as a source of income, aligning with your broader strategy to hedge parts of your portfolio. Exchanges like the Cboe quote these as premiums because the options themselves don't have inherent value beyond this price.
The premium's components are straightforward: intrinsic value, time value, and the implied volatility of the underlying asset. As expiration approaches, the time value drops toward zero, leaving the intrinsic value to mirror the difference between the asset's price and the strike price.
Factors Affecting Option Premium
Several key factors influence an option's premium, and you need to understand them to trade effectively. The underlying security's price is primary: if it rises, call option premiums increase while put premiums decrease, and vice versa if it falls.
Moneyness matters too—it's how far the asset's price is from the strike. Deeper in-the-money means a higher premium; further out-of-the-money reduces it, shifting value mostly to time value. The time until expiration also plays a role: more time boosts the time value portion, but as expiration nears, the premium relies more on intrinsic value. For instance, a deep out-of-the-money option expiring tomorrow is basically worthless.
Implied Volatility and Option Price
Implied volatility comes from the option's price itself, fed into pricing models to gauge future stock volatility, and it directly impacts the extrinsic value. If you're long on options, rising implied volatility boosts the premium because higher volatility increases the odds of the option ending in-the-money.
Conversely, falling volatility reduces the premium. Take this example: if you hold a call with 20% implied volatility and it jumps to 50%, your premium appreciates. Vega measures this—it's the premium change for a 1% shift in implied volatility.
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