Option Premium
The components of the premium and what determines an option’s price
What Is the Option Premium?
The option premium is the price you pay for the right to buy (call) or sell (put) the underlying asset. It is what you see when you look at an options chain — the price of the option itself. The premium is what the option seller receives as compensation for taking on the risk of the opposite position. The premium consists of two components: intrinsic value and extrinsic value (also called time value). The level of the premium is determined by several factors that pricing models such as Black-Scholes take into account. Understanding what makes up the premium is essential to judging whether an option is expensive or cheap and whether it is worth trading.
Intrinsic Value: The Fixed Part of the Premium
Intrinsic value is the amount by which an option is in the money — the immediate profit if exercised now. For a call, intrinsic value is the asset price minus the strike (if positive, otherwise zero). For a put, it is the strike minus the asset price (if positive, otherwise zero). Intrinsic value is a fixed quantity at any given moment; there is no uncertainty in its calculation. An XYZ call with a $100 strike when XYZ trades at $105 has exactly $5 of intrinsic value. Out-of-the-money options have zero intrinsic value. Intrinsic value is the deterministic part of the premium: it rises and falls with the underlying price and hits zero the moment the option stops being in the money.
Extrinsic Value: The Variable Part of the Premium
Extrinsic value (also called time value) is the amount of premium above intrinsic value. It represents uncertainty and the potential for price to change. An ATM option priced at $2 has $2 of extrinsic value because it has no intrinsic value. An ITM option priced at $7 with $5 of intrinsic value has $2 of extrinsic value. Extrinsic value is what you are buying when you buy an option — the opportunity to gain if the market moves in your favour. It declines over time (theta decay) and is affected by changes in implied volatility. OTM options consist almost entirely of extrinsic value. Extrinsic value is what option sellers expect to collect as their profit.
Factors That Affect the Level of the Premium
Several factors determine how high the premium is at any moment. The first is implied volatility (IV), the market’s expectation of how much the asset will move in future; higher IV means higher premiums. The second is time to expiration; the longer the option has, the more time value it carries, so the higher the premium. The third is the level of interest rates; higher rates generally mean higher premiums for calls. The fourth is whether the asset pays dividends; upcoming dividends typically increase put premiums. The fifth is the asset price relative to the strike. The sixth is the asset’s actual historical volatility. All of these combine in pricing models to produce the option’s theoretical price.
When Is a Premium Expensive or Cheap?
Judging whether a premium is expensive or cheap is one of the most important skills in options trading. A premium is expensive when implied volatility is high relative to its own history, implying the market expects a larger move than will probably occur. A premium is cheap when IV is historically low. Most traders buy options when IV is relatively low (cheap premiums) and sell options when IV is relatively high (expensive premiums). Time also affects value; near expiration, time value falls fast, which benefits sellers. Traders compare current implied volatility against the underlying’s own historical volatility to make this call. They also look at the volatility smile across strikes, to see whether premiums are balanced or skewed to one side.