Loading the player...

What is an 'Option Premium'

An option premium is the income received by an investor who sells or "writes" an option contract to another party. An option premium may also refer to the current price of any specific option contract that has yet to expire. For stock options, the premium is quoted as a dollar amount per share, and most contracts represent the commitment of 100 shares.

BREAKING DOWN 'Option Premium'

Investors who write 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 Affecting Option Premium

The main factors affecting an option's price are the underlying security's price, moneyness, 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 is true for call options.

The moneyness affects the option's premium because it indicates how far away the underlying security price is from the specified strike price. As an option becomes further in-the-money, the option's premium normally increases. Conversely, the option premium decreases as the option becomes further out-of-the-money. For example, as an option becomes further out-of-the-money, the option premium loses intrinsic value, and the value stems primarily from the time value.

The time until expiration, or the useful life, affects the time value, or extrinsic 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

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. The opposite is true if implied volatility decreases. For example, assume an investor is 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.

RELATED TERMS
  1. Step Premium

    A type of option where the cost of purchasing the option is paid ...
  2. Stock Option

    A privilege, sold by one party to another, that gives the buyer ...
  3. Premium Income

    1. In investing, income that is earned through the sale of an ...
  4. In The Money

    1. For a call option, when the option's strike price is below ...
  5. Out Of The Money - OTM

    A call option with a strike price that is higher than the market ...
  6. Intrinsic Value

    Intrinsic value is the actual value of a company or an asset ...
Related Articles
  1. Trading

    The Anatomy of Options

    Find out how you can use the "Greeks" to guide your options trading strategy and help balance your portfolio.
  2. Trading

    Getting A Handle On The Options Premium

    The price of an option, otherwise known as the premium, has two basic components: the intrinsic value and the time value. Understanding these factors better can help the trader discern which ...
  3. Trading

    What Drives An Option's Price?

    The primary drivers of an option’s price are the underlying stock’s current price, the option’s intrinsic value, its time to expiration and volatility.
  4. Trading

    A Guide Of Option Trading Strategies For Beginners

    Options offer alternative strategies for investors to profit from trading underlying securities, provided the beginner understands the pros and cons.
  5. Trading

    The Ins And Outs Of Selling Options

    Selling options can seem intimidating but with these tips, you can enter the market with confidence.
  6. Trading

    Options Hazards That Can Bruise Your Portfolio

    Learn the top three risks and how they can affect you on either side of an options trade.
  7. Trading

    Options Strategies for Your Portfolio to Make Money Regularly

    Discover the option-writing strategies that can deliver consistent income, including the use of put options instead of limit orders, and maximizing premiums.
  8. Trading

    Getting Started In Forex Options

    Stocks are not the only securities underlying options. Learn how to use FOREX options for profit and hedging.
RELATED FAQS
  1. How does implied volatility impact the pricing of options?

    Learn about two specific volatility types associated with options and how implied volatility can impact the pricing of options. Read Answer >>
  2. Do you have to be an expert investor to trade put options?

    Learn about investing in put options and the associated risks. Explore how options can provide risk, which is precisely defined ... Read Answer >>
  3. What role does intrinsic value play in put options?

    See why the concept of intrinsic value is so important in options trading and how investors use it to evaluate the worth ... Read Answer >>
  4. What role does intrinsic value play in call options?

    Understand why the concept of intrinsic value is important for options traders and how they can use it to estimate what a ... Read Answer >>
Hot Definitions
  1. Treasury Bill - T-Bill

    A short-term debt obligation backed by the U.S. government with a maturity of less than one year. T-bills are sold in denominations ...
  2. Index

    A statistical measure of change in an economy or a securities market. In the case of financial markets, an index is a hypothetical ...
  3. Return on Market Value of Equity - ROME

    Return on market value of equity (ROME) is a comparative measure typically used by analysts to identify companies that generate ...
  4. Majority Shareholder

    A person or entity that owns more than 50% of a company's outstanding shares. The majority shareholder is often the founder ...
  5. Competitive Advantage

    An advantage that a firm has over its competitors, allowing it to generate greater sales or margins and/or retain more customers ...
  6. Mutual Fund

    An investment vehicle that is made up of a pool of funds collected from many investors for the purpose of investing in securities ...
Trading Center