An option premium represents the current market price of an option contract. It serves as the income received by the seller (writer) of an option contract to another party. In-the-money option premiums comprise two factors: intrinsic and extrinsic value, whereas out-of-the-money option premiums consist purely of extrinsic value.
For stock options, the premium is quoted as a dollar amount per share, with most contracts representing the commitment of 100 shares.
Key Takeaways
- The option premium is its price in the market.
- Out-of-the-money contracts consist purely of extrinsic (time) value. In-the-money options consist of both intrinsic and extrinsic value.
- More time to expiration or higher implied volatility generally results in a higher premium.
Understanding Option Premium
Investors who write, or sell, calls or puts use option premiums as a source of current income aligned with a broader investment strategy to hedge all or parts of a portfolio. Prices of options quoted on exchanges like the Cboe Options Exchange are considered premiums since the options themselves lack intrinsic value.
An option premium comprises its intrinsic value, time value, and the implied volatility of the underlying asset. As the option nears its expiration date, the time value diminishes to $0, making the intrinsic value representative of the difference between the underlying security’s price and the strike price of the contract.
Factors Influencing Option Premium
The primary factors influencing an option’s price include the price of the underlying security, its moneyness, the useful life of the option, and implied volatility.
As the underlying security’s price fluctuates, so does the option premium. A rise in the underlying security’s price increases the premium of a call option but decreases the premium of a put option. Conversely, a fall in the underlying security’s price increases the put option’s premium, and the reverse is true for call options.
Moneyness reflects the proximity of the underlying security price to the specified strike price. An increase in moneyness for a given option likely results in a higher premium, while moving out-of-the-money causes a decrease in the option’s intrinsic value, leaving time value as the primary component of its premium.
The time remaining until expiration affects the time value portion of the option’s premium. As the expiration date approaches, the option’s premium is influenced predominantly by its intrinsic value. For instance, deep out-of-the-money options expiring imminently tend to be valued very close to $0.
Impact of Implied Volatility on Option Pricing
Implied volatility is derived from the option’s price and is fed into pricing models to indicate potential future price volatility of the underlying asset. It primarily affects the extrinsic value component of the option premiums. Investors hold long options when higher implied volatility adds value, as such volatility increases the chances of the option ending in-the-money. Conversely, a decrease in implied volatility reduces that value.
For instance, consider an investor holding a call option with an annualized implied volatility of 20%. An increase in implied volatility to 50% during the life of the option would enhance the call option’s premium. The change in premium due to a 1% alteration in implied volatility is measured by the option’s vega.
By fully understanding and analyzing these components, traders and investors can make more informed decisions in the options trading landscape.
Related Terms: Intrinsic Value, Extrinsic Value, Implied Volatility, Call Options, Put Options.
References
- Option Strategies Insider. “Understanding an Options Premium”.
