Option Premiums: What You Need to Know

Options can be used to express specific trading views, but before diving into options trading, you must understand how an option premium works — a vital component that can make or break your trading strategy. 

This guide will explain option premiums, the factors affecting them and how they can impact your trades.

What Is an Option Premium?

An option premium is the price the buyer pays the seller for the right granted by an option contract. It represents the current market price of the option and allows the buyer to buy or sell the underlying asset at a specified price on or before a specific expiration date.

The option premium has two components: intrinsic value and extrinsic value.

The intrinsic value represents the built-in profit if an option was to be exercised immediately and applies only to in-the-money call options where the underlying asset market price is higher than the option's strike price. Extrinsic value, or time value, accounts for the potential change in the option's value over time and is present in all options before expiration.

Out-of-the-money call options where the underlying asset market price is lower than the option's strike price have only extrinsic value, assuming its before expiration, while in-the-money options have intrinsic and extrinsic value in their premiums.

Option premiums are calculated on a per-share basis. As each option contract is typically equivalent to 100 shares, the option premium amount is multiplied by 100 to determine the total cost of the option. For instance, a premium of $1.50 per share translates to a $150 total cost for the contract. 

Factors Affecting Option Premium

Here are factors that influence the value of an option premium, illustrated with examples to help you understand their impact.

1. Underlying Security's Price

The price of the underlying security directly affects the option premium. If a company's stock price increases above the strike price, the premium on those call options may also increase. The option gives you the right to buy the company's stock potentially at a lower price than the market price. In the same way, the premium for put options – a strategy that gives you the right to sell the underlying stock – will decrease. 

For example, Company XYZ's stock price is $50. There are two options available, both expiring in a month:

Long positions:

• Call Option A: $55 strike price
• Put Option B: $45 strike price

Let's assume XYZ's stock price increases to $60. As a result, call option A becomes more attractive, and the premium increases. Because the current market price has further increased from put option B’s strike price, the premium drops.

2. Implied Volatility

Implied volatility represents the expected price fluctuation of the underlying security during the option's life. Higher implied volatility increases the option premium as the potential for significant price swings increases the possibility of the option expiring in the money.

Assume two pharmaceutical companies, PharmaA and PharmaB, have call options expiring in a month. PharmaA is stable, with a history of low price volatility, while PharmaB has an upcoming drug trial announcement, which could considerably spike its stock price.

Because of the difference in expected price fluctuations, the implied volatility for their call options will vary. PharmaB's call option, with higher implied volatility, will have a higher premium since higher implied volatility typically indicates greater expected fluctuations (in either direction) for the underlying security. Conversely, PharmaA will fetch a lower premium resulting from its lower implied volatility since its stock price is expected to remain relatively stable, which may lead to lower premiums.

3. Moneyness

Moneyness describes how far apart the underlying security's current price is from the option's strike price. Options can be in-the-money (ITM), at-the-money (ATM) or out-of-the-money (OTM). ITM options have higher premiums because of their intrinsic value, while OTM options have lower premiums as they possess only time value. 

4. Time Until Expiration

The time left until the options expire also affects the premium. Longer timeframes generally increase the likelihood that the options will become ITM, thus raising the premium. 

For instance, the stock price of Company ABC is currently $100. There are two call options available with different expiration dates, both with a strike price of $105:

• Call Option A: Expiration date in one month
• Call Option B: Expiration date in three months

The impact of the remaining time until expiration on the premiums would be as follows:

• Call Option A: With one month remaining, there's less time for the stock price to rise above the strike price. The premium might be $4, mainly consisting of time value.
• Call Option B: With three months remaining, there's a higher likelihood that the stock price will exceed the strike price, increasing the chance it becomes in the money. The premium might be $7, reflecting the additional time value.

The Greeks and Option Premiums

The Greeks are used to measure the sensitivity of options to various factors, like when the underlying moves or if implied volatility changes, among other things.

• Delta: Measures the change in an option premium relative to a change in the price of the underlying security.
• Gamma: Expresses the rate of change in the option's delta.
• Theta: Quantifies the effect of time decay on the option premium.
• Vega: Captures the sensitivity of the option premium to changes in implied volatility.
• Rho: Indicates the impact of interest rate changes on the option premium.

Example of an Option Premium

Imagine you purchase a call option on Company E's stock with a strike price of $100, an expiration date in two months and a premium of $5. If the stock price rises to $110 before the option expires, you can exercise it and buy the stock at $100, resulting in a $5 profit per share after accounting for the premium paid. If the stock price remains below $100, the option expires worthless, and you will lose the $5 premium paid for the option.

Understanding Option Premiums for Trading

Understanding the intricacies of option premiums can provide valuable insights into the world of options trading. By grasping the factors that affect option premiums and the role of the Greeks, you can be more strategic in your trading.

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