There are several specific phrases used in the stock and securities markets that are different from those used in everyday trade. The “option premium” is one such search keyword. When you wish to trade stocks and other securities, you can start by purchasing an option that gives you the right to do so at a predetermined price within a specified window of time in exchange for a premium. This quick guide explains option premiums in more detail.
What Is a Premium on an Option?
The current market price (what a buyer pays) of an option contract to trade (buy or sell) stocks and other assets is referred to as the option premium in finance and stock trade. The options contract has a fixed price that only expires when the time period specified in it runs out.
An option premium, from the standpoint of the seller (writer), is the money earned for an option contract if the option holder purchases shares or other securities. The price of a stock option is expressed or valued as a dollar amount per share. The majority of option contracts commit to 100 shares.
Parts of the Option Premium
Two essential elements make up an option premium:
- Extrinsic and internal values
Value in time
Fundamental Value (Calls)
The price an investor is willing to pay for a stock or other asset is its intrinsic value. When the price of the specific security is more than the strike price, it can also be referred to as a call option. If the option were to be exercised right now, its value would be this.
either intrinsic or extrinsic value (Puts)
Extrinsic value is defined as the discrepancy between the option’s actual intrinsic value and its market price, or premium. When the price of the underlying asset is lower than the strike price, the option is also known as a put option and is in the money.
Value at Time
The time value, which is frequently determined before expiration, is the difference between the premium and its intrinsic value.
Consider this formula: Time Value = Premium – Intrinsic Value.
It can be defined as the sum of money an investor is prepared to spend above the asset’s intrinsic value to acquire an option. It is the amount that would be expected to rise in value should the price of the underlying securities change favorably before the option’s expiration day.
The longer or more time there is for the market circumstances of the underlying investment to benefit the investor, the higher the time value.
Options Premium Determinants
Every investor always wonders, “What influences the price of the options premium?” The following six factors significantly influence an option’s premium:
- Changes in a security’s underlying price can make an option’s value higher or lower. The intrinsic and extrinsic values of the option are affected by changes in these prices in opposing ways.
- Option strike price: Whether or not an option has intrinsic value is determined by the option strike price. The inherent value (call) of the option declines as the strike price rises, whereas the intrinsic value (put) of the option rises.
- Due to the short lifespan of options, the amount of time left before they expire has an impact on their value. Both calls and puts typically lose or lose some of their time value as their expiration draws near. The option’s time value decreases most quickly in the final few days.
- Implied volatility: Despite being arbitrary and difficult to measure, volatility (risk uncertainty) has a substantial impact on the option’s premium time value. Higher volatility approximations denote anticipated higher price level variations (in either direction) for the security.
- Dividends: Although options don’t get dividends when corporations declare dividends, their stock value is typically impacted. If a corporation declares a dividend after that date, you will receive it, but the stock value will fall by the dividend’s amount.
- Interest rates: Although minimal, interest rates do have an impact on option premiums. It only has an impact on the share price of the underlying security. For instance, the call value will rise and the put value would fall as interest rates rise.
Understanding options is difficult and takes specialist knowledge, but if you comprehend the elements of options and the variables influencing their value, you can comprehend their pricing. You can use this to evaluate the potential benefits and hazards of each stock you intend to buy or sell.