Understanding Option Premium: A Comprehensive Guide

Options are flexible financial contracts that do not obligate the holder to take an action. Investors selling or writing off options often depend on the premium income. Investors also consider the option premium before making a decision, as it is a major cost in options trading. Before understanding the premium, strike prices, and other basic terms, you cannot trade options. Continue reading to understand in detail what an option premium is.

What is an Option Premium?

You must know that an option is a type of derivative that gives the holder the right to buy/sell the underlying asset on a future date, called the expiration date. The holder can buy/sell the underlying asset in an option at the strike price, which is the predetermined price of the asset. Option premium is the price of the financial contract with a particular underlying asset and strike price. You must pay the premium to purchase an options contract. On the other hand, you receive a premium on selling or writing off options. A range of factors help decide the premium for an option.

Factors

The price of an option depends on its intrinsic value and extrinsic or time value. Also, the implied volatility for the underlying asset helps determine the options price. Let us start with the relationship between the underlying asset’s market price and the options premium. Usually, the premium for call options increases when the market value of the underlying asset rises. However, the premium for put options decreases when the market value of the underlying asset rises.

The moneyness will also help determine the option premium. You might know that a call option becomes ITM (In-the-money) when the underlying asset’s market price is more than the strike price. Similarly, a put option goes to ITM when the market price is lower than the strike price. Options becoming in-the-money usually have higher premiums compared to out-the-money options.

The time value also impacts the option premium. As an option approaches its expiration date, it loses its intrinsic value, ultimately leading to zero. For the same rationale, the proximity of the expiration date will affect the premium for an option.

How Is it Calculated?

Now that you understand the meaning of the option premium, let us get to the calculation part. Let us start with an option’s intrinsic value and time/extrinsic value, as they help decide the premium. You can say that the premium for an option = intrinsic value + time value .

The intrinsic value for an option contract is calculated as the difference between the strike and spot prices. Spot price is the market value of the underlying asset on the expiration date. An ITM option will have a positive intrinsic value, as there is a gap between the spot and strike prices. However, the same cannot be said for an option with a strike price equal to the spot price. When the strike price is equal to the spot price, the difference between them is zero. This decreases the option premium for the investor. As the market value of the underlying asset changes, the premium for the associated option will change.

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Although extrinsic value is called the time value, it consists of many other factors. An option contract will have a fixed expiration date. The price or premium for the option can only swing before the expiration date. Once the expiration date arrives, the value of the contract becomes zero. An option becomes worthless once the expiration date is crossed without becoming in-the-money. Since the option did not become ITM, it will not be exercised.

This was only the theoretical part of the calculation of option premiums. The actual calculation of the premium for an option involves complex pricing models. These pricing models use a range of factors to calculate the premium for an option. Besides the intrinsic and extrinsic value, pricing models use implied volatility, interest rate, and other factors.

Black-Scholes Option Price Calculation Model

As discussed above, pricing models are used to calculate the option premium. The Black-Scholes model is a popular one used for options pricing. Here is the formula used by the Black-Scholes model to calculate the premium for a call option:

Premium for a call option = P * N(d1) – X * e^(-rt) * N(d2)

The premium for a put option is = X * e^(-rt) * N(-d2) – P * N(-d1)

In the above formulas, P and X are market and strike prices of the underlying asset, respectively. ‘t’ and ‘r’ are expiration date and interest rate, respectively. N(d1) and N(d2) are standard distributive functions (cumulative) in the above formulas. The components in the above formulas for option premium are represented in Greek: Delta, Gamma, Vega, Theta, and Rho.

Implied Volatility and Option Price

Implied volatility is the future price fluctuations predicted for an asset. It has a close relationship with the option premium. Implied volatility is itself calculated from the prices of options contracts based on a particular underlying asset. The same implied volatility is an input in the options pricing model like the Black-Scholes model. When the price of an asset rises or falls quickly and significantly, there is a change in the implied volatility. The implied volatility for a particular asset will increase when prices start rising or falling.

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As the implied volatility for an underlying asset increases, the premium for the option also rises. More people demand options with a rise in the implied volatility. Since people cannot predict the market direction with increased implied volatility, they choose options for risk management. On the other hand, the option premium will go down for an asset with low implied volatility.

In a Nutshell

The premium or price of an option depends on a range of factors, especially on the intrinsic and time value. Implied volatility also has a significant impact on the option premium. Usually, the Black-Scholes model is used to determine the prices for options. Investors must compare the premiums of different options to make the right decision. Check out other models for calculating the premium for options now!