What Is An Option Premium?
An option premium is the price an option holder pays to purchase or sell options contracts at a fixed rate when the contract term ends. In other words, it is the current market price of an option contract, and the amount the seller makes 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 the amount that the option writer receives if the contract holder exercises their right to buy or sell the asset.
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 are familiar with the process of investing in and trading options, but the other side of the market is to be on the seller side (writing options) and make a profit by selling for a premium.
Selling options is an options trading strategy in which an investor sells a buyer the right to purchase a stock at a predetermined price at some time in the future. The premium amount is collected upfront as a payment for the options seller taking on the risk that the underlying asset will rise or fall in value within the timeframe of the contract. The premium is not refundable.
The options seller can make a profit from the premium. In addition, if the buyer doesn’t exercise their right to trade the asset, when the contract expires the seller still holds the asset as well.
However, option selling also carries some investment risk. If the option ends up “in the money” for the buyer, the option writer could lose money, since they’ll have to sell the stock for less than its market price.
How Is an Options Premium Calculated?
The main factors that affect an option contract price are implied volatility, stock price, time value, and intrinsic value. Options writers receive premiums upfront when a buyer purchases a call or a put.
When an investor looks at options contract prices, they receive a per share quote, but each contract typically represents 100 shares of underlying stock. Investors 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, an investor could decide to purchase a call option. The seller offers it to them for a $4 premium. If the investor 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 is at or below the strike price when the contract expires), the seller’s profit is $400, or the entire premium.
Stock Price
If an investor buys 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 goes up and the put option premium goes down. And vice versa.
Recommended: What Makes Stock Prices Go Up or Down?
Time Value
Time value reflects the expiration date of the option contract. If the option has a longer time left until its expiration date, it has more time to pass the strike price. That makes it more valuable because it gives the investor more time to exercise their right to trade for a profit. The decrease in time value over time is called time decay.
The closer the option gets to expiring, the more the time decay increases. The value of the options contract declines over time due to time decay, which is a risk investors should consider. Options buyers want the stock to quickly move up and down so that the time decay doesn’t affect their profits, whereas options sellers want the premium to decrease, which happens with every day that goes by.
Time value is calculated by subtracting intrinsic value from the premium.
Intrinsic Value
The intrinsic value of options 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 how far in the money the option is.
If the price of the underlying asset is higher than the option 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 contract 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.
Implied Volatility
High premium options often reflect securities with higher volatility. If there is a high level of implied volatility, this means there is a prediction that the underlying asset will have bigger price moves in the future, making the option more expensive.
A low level of implied volatility will make it cheaper. It’s best for investors to purchase options that have steady or increasing volatility, because this can lead to bigger profits and a higher likelihood that the option will reach the investor’s desired price. Those who are selling options prefer to have decreasing volatility, because this lowers the premium and allows them to buy back the option at a lower price.
Other Factors
Other factors that influence 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. Investors can look at each type of risk to figure out which options they want to buy.
• Delta: The sensitivity of an option price to changes in the underlying market
• Gamma: The amount that an option’s delta moves with each point of movement of the underlying market asset
• Theta: That amount that an option price decays over time
• Vega: The amount that underlying market volatility affects the option
• Rho: The amount that interest rate changes affect the option price
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 determine the future price of that asset.
If you’re ready to keep learning about options and try your hand at options trading, you may consider checking out SoFi’s options trading platform. The platform’s user-friendly design allows investors to trade through the mobile app or web platform. Plus, you’ll have information you need at your fingertips, thanks to an educational content hub.
Photo credit: iStock/sefa ozel
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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.
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