Option Premium – Everything You Need to Know

Cole Turner

Option Premium

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.

Intrinsic Value

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.

Time Value

The time value of an option contract is dependent upon the length of time remaining before the option contract expires.

Exclusive  Covered Call – Option Trading Strategy

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

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.

 

Like This Article?
Now Get Mark's FREE Special Report:
3 Dividend Plays with Sky-High Returns

This newly-released report by a top-20 living economist details three investments that are your best bets for income and appreciation for the rest of the year and beyond.

Get Access to the Report, 100% FREE


img
previous article

Tony Zhang is the chief strategist at OptionsPlay, a company that offers an intuitive yet sophisticated options trading platform aimed at removing complexity out of trading options to let users focus on making investment decisions. He

PREMIUM SERVICES FOR INVESTORS

Dr. Mark Skousen

Named one of the "Top 20 Living Economists," Dr. Skousen is a professional economist, investment expert, university professor, and author of more than 25 books.

Product Details

LEARN MORE HERE

Bryan Perry

A former Wall Street financial advisor with three decades' experience, Bryan Perry focuses his efforts on high-yield income investing and quick-hitting options plays.

Product Details

LEARN MORE HERE

Jim Woods

Jim Woods has over 20 years of experience in the markets from working as a stockbroker,
financial journalist, and money manager. As well as a book author and regular contributor to
numerous investment websites, Jim is the editor of:

Product Details

LEARN MORE HERE

Bob Carlson

Bob Carlson provides independent, objective research covering all the financial issues of retirement and retirement planning. In addition, Bob serves as Chairman of the Board of Trustees of the Fairfax County (VA) Employees’ Retirement System, which has over $2.8 billion in assets.

Product Details

LEARN MORE HERE

Mike Turner

Mike Turner’s financial, mathematical, computer science and engineering background serves as the foundation for his disciplined, rules-based approach to trading. Mike’s three services include:

Product Details

LEARN MORE HERE

Hilary Kramer

Hilary Kramer is an investment analyst and portfolio manager with 30 years of experience on Wall Street. Since 2010, Hilary's financial publications have provided stock analysis and investment advice to her subscribers:

Product Details

LEARN MORE HERE

DividendInvestor.com

Used by financial advisors and individual investors all over the world, DividendInvestor.com is the premier provider and one-stop shop for dividend information and research.

Product Details

Popular tools include our proprietary Dividend Calendar, Dividend Calculator, Dividend Score Card, and many more.

LEARN MORE HERE