An option premium is the price that a buyer pays to purchase an options contract. It is also the amount that the seller, or option writer, receives for taking on the obligation associated with the contract.
Whether the option is a call option or a put option, the buyer must pay a premium upfront to enter the trade. The premium represents the maximum amount an option buyer can lose if the trade does not work out as expected.
When a trader buys an option, they pay a premium to obtain the right to buy or sell the underlying asset at the strike price.
The premium is paid upfront and is non-refundable. Once the premium is paid, the buyer can hold the option until expiry, sell it before expiry, or exercise it if the contract allows.
For the seller, the premium received is the maximum profit that can be earned from the trade if the option expires worthless.
Example
Suppose Nifty is trading at 23,500.
A trader expects the index to move higher over the next few days and buys a Nifty call option with a strike price of 23,600. The option is trading at a premium of ₹120, which the trader pays upfront to enter the trade.
A few days later, Nifty rises to 23,800. As a result, the value of the call option also increases, and its premium rises from ₹120 to ₹180.
The trader decides to sell the option and exit the position. Since the option was purchased for ₹120 and sold for ₹180, the trader earns a profit of ₹60 per unit.
Now consider a different outcome. Instead of moving higher, suppose Nifty falls or remains below 23,600 until expiry. In this case, the option may expire worthless, and the trader loses the premium paid, which is ₹120 per unit.
What determines an option's premium?
Several factors influence the premium of an option:
1. Price of the underlying asset
Changes in the price of the underlying asset affect the value of the option, where the premium of a call option generally increases when the price of the underlying asset rises, while the premium of a put option generally increases when the price of the underlying asset falls.
2. Strike price
The relationship between the strike price and the current market price of the underlying asset affects the premium. Options that are already profitable to exercise generally have higher premiums than those that are not.
3. Time to expiry
Options with more time remaining until expiry usually have higher premiums because there is a greater chance that the option could become profitable before expiry. As expiry approaches, this time value gradually declines, a phenomenon known as time decay.
4. Volatility
Volatility measures how much the price of the underlying asset is expected to fluctuate. Higher volatility generally leads to higher option premiums because larger price movements increase the likelihood of the option becoming profitable.
5. Interest rates and dividends
Interest rates and expected dividends can also influence option premiums, although their impact is often smaller than factors such as price, time, and volatility.
What are intrinsic value and time value?
An option's premium consists of two components:
Intrinsic value
Intrinsic value is the value an option would have if it were exercised immediately.
- For a call option, intrinsic value exists when the market price is above the strike price.
- For a put option, intrinsic value exists when the market price is below the strike price.
Time value
Time value is the portion of the premium that reflects the possibility of the option becoming more valuable before expiry. The longer the time remaining until expiry and the higher the expected volatility, the greater the time value tends to be.
Why is option premium important?
Option premium determines:
- The cost of entering an options trade.
- The maximum possible loss for an option buyer.
- The maximum profit an option seller can earn if the option expires worthless.
- The potential return on an options position.
Understanding how option premiums are calculated can help traders evaluate whether an option is expensive or inexpensive relative to market conditions. To learn more about options, visit the Options Theory module on Varsity.