Editor's Note: Options are not suitable for all investors. Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Please see the Characteristics and Risks of Standardized Options.
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Options traders may sell (or write) options with the hope of profiting from the premium they receive in return. Options premiums are the fee that options buyers (or holders) pay to purchase an options contract, giving them the option — though not the obligation — to buy or sell an asset at a specific price by a set date.
Unlike options holders, option writers are obligated to fulfill the terms of an options contract in exchange for the premium they receive, which could expose them to the risk of seeing substantial losses, well beyond losing the premium they receive.
While option writing has the potential to generate profits, it’s an advanced investment strategy typically used by traders experienced with risk management techniques.
Key Points
• Selling options generates income via writing call or put contracts, collecting upfront payments.
• Factors affecting option premiums include stock price, time value, and implied volatility.
• Potential losses if the option is exercised represent a significant risk.
• Retaining premiums and assets is a benefit if options are not exercised.
• Financial advice is crucial before trading options due to their complexity and risk.
What Is An Option Premium?
An option premium is the price an option buyer pays to purchase a contract based on its upfront market cost. A seller, conversely, receives the premium upfront as compensation. In other words, it is the current market price of an option contract, and the amount the seller receives when someone purchases the contract.
When investors buy options contracts, they are purchasing a derivative instrument that gives them the right to trade the underlying asset represented by the contract at a specific price within a predetermined period of time. The premium is paid to the option writer at the time of sale, regardless of whether the buyer exercises the option.
The premium amount depends on how much time there is left until the option contract expires, the price of the underlying asset, and how volatile or risky it is.
Recommended: How To Trade Options: A Guide for Beginners
What Is Selling Options Premium?
Many investors may be familiar with the concept of purchasing an option contract, but on the other side of the market are the sellers who generate income through the premiums they receive from buyers.
Selling options is an options trading strategy in which an investor sells a buyer the right to purchase or sell an asset (typically a stock) at a predetermined price by the option’s expiration date. The premium is collected upfront as payment for the seller taking on the risk that the price of the underlying asset may move in the buyer’s favor during the contract’s term. The premium is not refundable.
If the option expires worthless, and the buyer isn’t able to exercise their right to buy or sell the underlying asset, the seller gets to keep the premium as profit, as well as retain ownership of the underlying asset (in the case of call options).
However, if the option ends up “in the money” for the buyer, the seller could incur a loss, since they’ll have to sell the stock for less than (or buy it for more than) its market price.
How Is an Options Premium Calculated?
The main factors that affect an option contract price are its intrinsic value, as determined by the stock price and strike price, implied volatility, and time value. Options sellers receive premiums upfront when a buyer purchases a call or a put option.
When an option buyer looks at options contract prices, they receive a per share quote, but each contract typically represents 100 shares of the underlying stock. Buyers will decide to either buy call or put options, depending on how they expect the stock’s price to perform in the future.
For example, a buyer could decide to purchase a call option. The seller offers it to them for a $4 premium. If the buyer purchases one contract, which represents 100 shares of that stock, they would pay $400 for it. If the buyer never executes the contract (because the price of the stock doesn’t move in their favor before the contract expires), the seller may keep the full $400 premium as compensation.
Stock Price
If an option buyer purchases a call option, they are hoping the underlying stock price increases, whereas if they buy a put option they hope it decreases. When the stock price goes up, the call option premium tends to increase and the put option premium tends to decrease. When the stock price falls, the call premium decreases and the put premium increases.
Recommended: What Makes Stock Prices Go Up or Down?
Intrinsic Value
The intrinsic value of an option is the difference between the current underlying stock price and the option’s strike price. This difference is referred to as the “moneyness” of the option, where the intrinsic value of the option is a measure of how far in the money the option is.
If the price of the underlying asset is higher than the option’s strike price, a call option is in the money, making it worth more and priced higher. If the stock price is lower than the option’s strike price, this makes a put option in the money and worth more. If an option is out of the money, it has no intrinsic value.
Time Value
Time value is the portion of the option’s premium that exceeds its intrinsic value due to time remaining before expiration. If the option has a longer timeframe left until its expiration date, it has more time to potentially move beyond the strike price and into the money. That makes it more valuable because it gives the investor more time to exercise their right to trade for a potential gain. The decrease in time value over time is called time decay.
The closer the option gets to expiring, the more rapidly time value erodes (and time decay increases). The value of the options contract declines over time due to time decay, which can be a risk for buyers. Options buyers want the stock to move enough, and soon enough to increase the option’s value before time decay reduces it. On the other hand, options sellers want the premium to decrease, which happens with every day that goes by.
Time value, sometimes referred to as extrinsic value, is calculated by subtracting intrinsic value from the option’s premium.
Implied Volatility
High premium options often reflect securities with higher volatility. If there is a high level of implied volatility, it suggests the underlying asset may experience larger price swings in the future, making the option more expensive.
A low level of implied volatility can make the option premium lower. It may benefit buyers to consider options with steady or increasing volatility, because this can increase the chance of the option reaching the desired strike price. Those who are selling options may prefer lower volatility because it may reduce the risk of large price swings, and could create an opportunity to buy back the option at a reduced price.
Other Factors
Other factors that influence option premium prices include:
• Current interest rates
• Overall market conditions
• The quality of the underlying asset
• Any dividend rate associated with the underlying asset
• The supply and demand for options associated with the underlying asset
Options Premiums and the Greeks
Certain Greek words are associated with types of risks involved in options trading. Traders can look at each type of risk to figure out which options they may consider trading, and how those trades might respond to factors like price changes, volatility, or time decay.
• Delta: The sensitivity of an option price to changes in the underlying asset
• Gamma: The expected rate of change in an option’s delta for each point of movement of the underlying asset
• Theta: The rate at which an option’s price decays over time
• Vega: A measure of the amount the option’s price may change for each 1% change in implied volatility
• Rho: The expected change in an option’s price for a one percentage point change in the risk-free interest rate
The Takeaway
Options are one type of derivatives that give the buyer the right, but not the obligation, to buy or sell an asset. To sell options for a premium, options writers must consider several factors that could influence the option’s premium value. Selling options for premium is potentially a strategy that may allow sellers to generate income. However, given that option writing has the potential to result in substantial losses, it should only be undertaken by experienced traders.
While investors are not able to sell options on SoFi’s options trading platform at this time, they can buy call and put options to try to benefit from stock movements or manage risk.
FAQ
How do you sell options to collect premium?
To sell options to collect premium, a trader writes call or put contracts and receives payment upfront from the buyer. This strategy involves agreeing to buy or sell a stock if the buyer exercises the option by expiration. Common strategies include covered calls and cash-secured puts.
What happens to the premium when you sell an option?
When an option is sold, the premium is paid upfront to the seller. If the seller holds the position to expiration and the contract is not exercised, they may keep the full amount. But if they close the position early by buying it back, the final result depends on the repurchase price.
What is the premium when you sell an option?
The premium when selling options is the amount a buyer pays for the contract. It compensates the seller for taking on the obligation to buy or sell the underlying asset if the option is exercised.
How is the premium of an option determined?
An option’s premium is based on intrinsic value, time value, implied volatility, and the price of the underlying stock. The final premium reflects current market expectations of risk and time until expiration.
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Options involve risks, including substantial risk of loss and the possibility an investor may lose the entire amount invested in a short period of time. Before an investor begins trading options they should familiarize themselves with the Characteristics and Risks of Standardized Options . Tax considerations with options transactions are unique, investors should consult with their tax advisor to understand the impact to their taxes.
Disclaimer: The projections or other information regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results.
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