Stock and securities trading have some particular terms different from normal terms in general commerce. One search term is the ‘option premium.’ When you want to trade stock and other securities, you may begin by buying an option for which you pay a premium for the right to trade at a preset price within a time limit. This brief guide helps you learn more about option premiums.
What Is an Option Premium?
In finance and stock trade, the term option premium refers to the current market price (what a buyer pays) of an option contract to trade (buy or sell) stocks and other securities. The options contract has a preset price that ends only when its time limit expires.
From a seller’s perspective, an option premium is the income a seller (writer) receives for an option contract if the option holder buys a stock or other securities. Stock option premiums are quoted/assessed as a dollar amount per share. Most options contracts are for 100 shares commitment.
Components of Option Premium
An option premium has two key components:
- Intrinsic value and extrinsic value
- Time value
Intrinsic Value (Calls)
Intrinsic value is the investor’s willingness to pay for an asset such as stock. It can also be called a call option to indicate when the particular security’s price is higher than its strike price. This is the option’s value if it were to be exercised today.
Extrinsic value or Intrinsic Value (Puts)
Extrinsic value is explained as the difference between the option’s market price, or the premium, and its actual intrinsic value. It’s also called a put option to mean in-the-money when the underlying asset’s price is less than its strike price.
Time value is the difference between the premium and its intrinsic value, often calculated before expiration.
For instance: Time Value = Premium — Intrinsic Value
It can be explained as the money an investor is willing and ready to pay for an option (asset) above its intrinsic value. It’s an amount showing hope for the option’s value to increase before its expiration day with a favorable change in the underlying security price. Time value increases with the length or amount of time available for the underlying security’s market conditions to work to the investor’s benefit.
Factors Affecting Options Premium
The question in every investor’s mind is always, “what factors affect the price of options premium?” There are six main factors affecting an options premium:
- Underlying price: Changes in a security’s underlying price can decrease or increase an option’s value. Changes in these prices have opposite effects on the option’s intrinsic and extrinsic value.
- Option strike price: The option strike price determines whether or not an option has intrinsic value. As the strike price increases, the option’s call value (intrinsic value) decreases while the option’s put value (extrinsic value) increases.
- Time until expiration: Since options have a limited lifespan, time towards their expiration affects their value. Generally, their time value erodes or decreases as their expiration approaches for both calls and puts. The option’s last few days see the most rapid decrease in time value.
- Implied volatility: Although volatility (risk uncertainty) is subjective and hard to quantify, it significantly affects the option’s premium time value. Higher volatility approximations indicate expected greater fluctuations (in either direction) of the security’s underlying price levels.
- Dividend: Generally, although options don’t receive dividends, their value is affected when companies release dividends. Their ex-dividend date means that if a company releases a dividend, you will receive a dividend, but the stock value will decrease by the dividend’s amount.
- Interest rate: The effect of interest rate on option premiums is small but measurable. It only affects the cost of carrying the underlying security shares. For example, when the interest rates rise, the call value will increase, and the put value will decrease.
Understanding options is complicated and requires expert knowledge, but if you understand Options components and factors affecting its value, you can understand its pricing. This will help you assess the possible rewards and risks of every stock you want to buy or sell.
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