Understanding the Options Premium

Investors love options because they improve many market strategies. Think a stock is going to rise? If you're right, buying a call option gives you the right to buy shares later at a discount to the market value. That means big profits if the stock actually rises. Want to lower your risk if your stock unexpectedly plummets? With a put option, you can sell the stock later at a preset price and limit your losses.

Options can open the door to big gains or provide a safeguard against possible losses. And, unlike buying or short-selling shares, you can obtain a significant position with modest upfront capital. Whether you’re buying or selling these contracts, understanding what goes into an option’s price, or premium, is essential to long-term success. The more you know about the premium, the easier it will be to recognize a good deal.

Key Takeaways

  • The option premium is the total amount that investors pay for an option.
  • The intrinsic value of an option is the amount of money investors would get if they exercised the option immediately.
  • The time value of an option is whatever investors are willing to pay above the intrinsic value, in hopes the investment will eventually pay off.
  • The option premium is higher for assets with higher price volatility in the recent past.

Intrinsic Value

There are two basic components to option premium. The first factor is the intrinsic value. The intrinsic value of an option is the amount of money investors would get if they exercised the option immediately. It is equal to the difference between the strike or exercise price and the asset's current market value when the difference is positive.

For example, suppose an investor buys a call option for XYZ Company with a strike price of $45. If the stock is currently valued at $50, the option has an intrinsic value of $5 ($50 - $45 = $5). In this case, one could exercise a call contract right away to receive $500 ($5 x 100 shares). Such an option is known as in the money.

However, if one buys a call option for XYZ with a strike price of $45 and the current market value is only $40, there is no intrinsic value. That is known as being out of the money. The second component of the option premium now comes into play, detailing the length of the contract.

Time Value

Your options contract may be out of the money but eventually have value due to a significant change in the underlying asset's market price. That is the time value of an options contract. Roughly translated, it signifies whatever price an investor is willing to pay above the intrinsic value, in hopes the investment will eventually pay off.

For example, suppose someone buys the XYZ call option with a strike price of $45 and the underlying plunges from $50 to $40. The option is now out of the money. However, the stock might rally and put the option back into the money in a few months.

The option price includes the bet the stock will pay off over time. Suppose a speculator buys a call option with a strike price of $45, and it had an intrinsic value of $5 since the stock was selling at $50. Investors might be willing to pay an extra $2.50 to hold a one-year contract because they expect gains for the stock. That would make the total option premium $7.50 ($5 intrinsic value + $2.50 time value = $7.50 premium).

It naturally follows that options that expire later have higher time value, all other things being equal. An option that expires in one year might have a time value of $2.50, while a similar option that expires in a month has a time value of just $0.20.

The Changing Value of Options

The option premium is continually changing. It depends on the price of the underlying asset and the amount of time left in the contract. The deeper a contract is in the money, the more the premium rises. Conversely, if the option loses intrinsic value or goes further out of the money, the premium falls.

The amount of time left in the contract also affects the premium. For example, the premium will decline as the contract gets closer to expiration. However, the pace of the decline can vary considerably. This time decay is a significant factor in time value computation.

Many options expire worthless, so accounting for time decay is crucial for avoiding and limiting losses.

You’re probably not going to pay a large sum for a blue chip's call or put in the 30-day window before expiration. It works that way because the odds for a large scale price movement are low in a short period. Consequently, its time value will taper off well ahead of expiration.

Measuring Volatility

In general, the option premium is higher for assets with higher price volatility in the recent past. Option premiums for volatile securities, like hot growth stocks, tend to decay more slowly. With these instruments, odds for an out of the money option reaching the strike price are substantially higher. Therefore, the option holds its time value longer.

Due to these variations, an options trader should measure the stock's volatility before placing a bet. One common way to accomplish this task is by looking at the equity’s standard deviation. Based on historical data, the standard deviation measures the degree of movement up and down in relation to the mean price. A lower number indicates a relatively stable stock, which usually commands a smaller option premium.

The Bottom Line

Options support a variety of strategies for seasoned investors, but they do carry risks. Learning about pricing factors, including volatility, increases the odds options will pay off with higher returns. However, investors should study the option Greeks to gain a better understanding of the option premium.

Article Sources
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  1. U.S. Securities and Exchange Commission. "Investor Bulletin: An Introduction to Options."

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