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.
Underlying Asset Price
The price of the underlying asset significantly influences the option premium. When the price of the underlying goes up (for a call option) or down (for a put option), the premium generally increases due to a higher probability of the option being in-the-money at expiration.
Strike Price
The connection between an option's strike price and the current market price of the underlying asset has a notable impact on its premium. Options that are in-the-money tend to have higher premiums compared to out-of-the-money options because they possess intrinsic value.
Time to Expiration
The time left until an option expires affects its premium. Usually, the more time that remains, the higher the premium, as there is a greater chance of price movements that could raise the option's value, which is referred to as time value.
Volatility
Market volatility plays an important role, as greater volatility enhances the likelihood of large price fluctuations in the underlying asset. This uncertainty results in higher option premiums due to the increased chances of the option ending up in-the-money.
Interest Rates
Interest rate fluctuations can influence option premiums, especially for longer-term options. When interest rates rise, call option premiums may increase while put option premiums may decrease due to the higher cost of holding an asset, which affects the present value of the strike price.
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.
Frequently Asked Questions
What is the purpose of an option premium?
An option premium serves to compensate the seller of the option for the risk involved in granting the buyer the right, but not the obligation, to buy or sell an underlying asset at a set price. It indicates the amount the buyer is prepared to pay for this potential opportunity, considering both the inherent worth of the option and the market’s predictions of future volatility.
Who pays the premium in an option contract?
The buyer of the option pays a premium to the seller for the right to buy or sell the underlying asset at a set price within a specific time period. This premium covers the cost of the option and compensates the seller for the risk involved in providing the option to the buyer.
Why are option premiums so high?
Option premiums have risen because of heightened market volatility and the need for protective hedges, as investors look to mitigate risk in uncertain conditions. Moreover, elements like time decay and the underlying asset’s likelihood of substantial price changes can also contribute to the increased cost of options.