What Is an Option Premium?
An option premium is the current market price of an option contract. It is thus the income received by the seller (writer) of an option contract to another party. In-the-money option premiums are composed of two factors: intrinsic and extrinsic value. Out-of-the-money options’ premiums consist solely of extrinsic value.
- The premium on an option is its price in the market.
- Option premium will consist of extrinsic, or time value for out-of-the-money contracts and both intrinsic and extrinsic value for in-the-money options.
- An option’s premium will generally be greater given more time to expiration and/or greater implied volatility.
Understanding Option Premium
Investors who write, which means to sell in this case, calls or puts use option premiums as a source of current income in line with a broader investment strategy to hedge all or a portion of a portfolio. Option prices quoted on an exchange, such as the Chicago Board Options Exchange (CBOE), are considered premiums as a rule because the options themselves have no underlying value.
The components of an option premium include its intrinsic value, its time value, and the implied volatility of the underlying asset. As the option nears its expiration date, the time value will edge closer and closer to $0, while the intrinsic value will closely represent the difference between the underlying security’s price and the strike price of the contract.
Factors of Option Premium
The main factors affecting an option’s price are the underlying security’s price, moneyness, the useful life of the option, and implied volatility. As the price of the underlying security changes, the option premium changes. As the underlying security’s price increases, the premium of a call option increases, but the premium of a put option decreases. As the underlying security’s price decreases, the premium of a put option increases, and the opposite are true for call options.
The time until expiration, or the useful life, affect the time value portion of the option’s premium. As the option approaches its expiration date, the option’s premium stems mainly from the intrinsic value. For example, deep out-of-the-money options that are expiring in one trading day would normally be worth $0, or very close to $0.
Implied Volatility and Option Price
Implied volatility is derived from the option’s price, which is plugged into an option’s pricing model to indicate how volatile a stock’s price may be in the future. Moreover, it affects the extrinsic value portion of option premiums. If investors are long options, an increase in implied volatility would add to the value. This is because the greater the volatility of the underlying asset, the more chances the option has of finishing in the money. The opposite is true if implied volatility decreases.
For example, assume an investor is a long one-call option with an annualized implied volatility of 20%. Therefore, if the implied volatility increases to 50% during the option’s life, the call option premium would appreciate in value. An option’s vega is its change in premium given a 1% change in implied volatility.