An option premium is the price paid by the buyer to the seller for an option contract.
Premiums are quoted on a per-share basis because most option contracts represent 100 shares of the underlying stock. Thus, a premium that is quoted as $0.10 means that the option contract will cost $10.
Whether an investor wants to buy or sell options, understanding what makes up an option’s premium is crucial in trading options. Intrinsic value, time value and implied volatility are the three components that determine the price of an option premium. Knowing what these components are and how they affect an option’s premium will help investors recognize a good deal from a bad deal in option contracts.
The intrinsic value of an option contract is the difference between the strike price and market price of the underlying stock.
For example, assume Disney (NYSE:DIS) has a market price of $105. If an investor buys a call option for DIS with a strike price of $100, then it has an intrinsic value of $5. This is known to be “in-the-money.” An investor could buy this option and reap a $500 profit right away.
If an investor buys a call option for DIS with a strike price of $100, but the market price of DIS is $95, then there is no intrinsic value. This is known as being “out-of-the-money.”
The farther “in-the-money” an option is, the more expensive the premium will be.
The time value of an option contract is dependent upon the length of time remaining before the option contract expires.
The more time an option has until expiration, the greater the time value is. As the option approaches its expiration date, the time value decreases. When the option expires, it becomes worthless.
Implied volatility is used to indicate how volatile a stock’s price may be in the future. High implied volatility means that the market predicts that the stock will have large price swings in either direction. Low implied volatility means that the market predicts that the stock will not swing in either direction significantly.
Higher implied volatility indicates a higher premium price. Whereas a lower implied volatility indicates a lower premium price.
For example, if a call option has an annualized implied volatility of 30% and the implied volatility increases to 50% during the option’s life, then the premium on the call option would increase.
Understanding how these three factors affect option premiums will prepare investors to differentiate between reasonable and unreasonable option premiums. This understanding will increase investors’ chances in getting a big return on investment from trading options.