Understanding option premiums isn’t nearly as complicated as you might think. Once you understand how to trade options, you’ll see that the option premium is simply the current price of a stock option. The buyer of an options contract has the right — but not the obligation — to buy or sell an underlying asset and the option premium is simply the price you pay for having such an opportunity.
In this article, we’ll review the basics of trading options, explore what the option premium is, and cover the two main drivers of option premium pricing — all with the end goal of getting you closer to trading option contracts with more confidence.
The Basics of Trading Options With an Option Premium
Let’s begin at the beginning. There are two types of options: call options and put options.
Trading Calls and Puts
A call option provides the buyer with the right to buy an underlying stock from the seller.
For example, imagine you purchase a call option for XYZ Company stock and the option’s strike price is $10. That means you’re expecting the price of XYZ stock to rise above $10 before the option expires. So you could buy XYZ for $10 when the stock market says it’s really worth more.
A put option provides the buyer with the right to sell shares of the underlying stock.
For example, let’s say you buy a put option for XYZ Company stock with a strike price of $10. This means you are expecting the price of XYZ stock to trend below $10 before the option expires. You don’t want to sell the stock now, but you want to protect yourself in case the stock price falls. In this sense, purchasing a put option can be like buying an insurance policy for stock that you already own.
The Option Premium
For both types of options contracts, an option premium is agreed upon at the time of exchange. Notice we didn’t say the option premium is paid at the time of exchange. Expressed in dollars, the option premium is actually credited or debited two business days after the options contract is brokered.
Premium prices are quoted as a per-share amount. So an option premium stated as $0.25 reflects a premium payment of $25 per option contract, since the contract typically represents 100 shares.
The writer — or the option seller — of either option receives and keeps the premium, even if the option buyer never exercises the option. However, the option seller also now has an obligation to the purchaser of the option. Should the purchaser decide to exercise the option to either buy or sell stock, the option seller must comply — even if the transaction is now financially unfavorable for the seller.
How to Think About Option Premiums
Now that we’ve got the details and facts covered, let’s talk about practical application.
The premium, or the option price, is what the option holder pays to buy the option (for both calls and puts).
Another way to look at the options premium is this: The person who writes or sells the option receives a premium. The seller “earns” that premium in exchange for accepting the obligation to buy or sell the underlying asset, should the holder of the option contract decide to exercise his or her right to buy or sell the asset.
Option premiums are charged per contract. For example, let’s say you decide to buy a call option contract for XYZ stock at a strike of $40. The premium for that call option might be priced at $3 per share. If you buy one contract, which controls 100 shares of the stock, you’d pay a $300 premium in total.
What Drives the Pricing on Option Premiums?
Essentially the more risk there is, the higher premium will be. But to truly understand option premiums, it’s important to understand what drives the premium’s pricing. Two components of the value of the option itself play a part here: intrinsic value and extrinsic value.
The intrinsic value of an option contract is the price difference between the stock price and the strike price at the time of valuation.
Suppose you own call options, which give you the right to buy 100 shares of XYZ at $10 a share — $10 is the strike price. If shares of XYZ are currently trading at $20 a share, that’s the market value, or stock price. The difference between the stock price and the strike price ($20-$10 = $10) is the intrinsic value of the option.
When options have intrinsic value, they’re considered to be “in the money” or ITM options. So the option described above is “in the money”.
If the stock price in the example above dipped below $10 per share, it would be worthless. This type of option contract is “out of the money” (OTM options), it will have zero intrinsic value. Negative intrinsic value doesn’t exist.
Put options work the same, except they have intrinsic value when their strike price is above the current stock price.
Also known as time value, extrinsic value indicates the likelihood that the option contract holder will see the price of the underlying security move in a favorable direction. As the contract approaches the expiration date, extrinsic value naturally diminishes.
Extrinsic value of the premium is affected by two factors: time and implied volatility of the underlying asset.
First, let’s look at time. The longer the time-lapse of a contract, the more difficult it will be to predict how the stock price of the underlying asset will behave. Even if the market is especially bullish or bearish, it isn’t likely to remain that way, so as the days pass, the option contract naturally loses value due to time decay.
The extrinsic value of the premium is also affected by historical and implied volatility. Historical volatility reflects how the price of the underlying asset has behaved over its lifetime. Implied volatility reflects market expectations for the underlying asset’s future price fluctuation.
The higher the volatility of an asset, the more likely you are to see dramatic price fluctuation – and so the more likely it is the option will end up having intrinsic value. Option sellers want to be compensated for this elevated risk, so they drive the price of the option premium up. As an option contract approaches the expiration date, extrinsic value has less of an impact on the price of the premium until the premium hits zero at the expiration date.
Trading Options With Confidence
According to the Wall Street Journal, options trading has become quite popular.
Highly sophisticated options traders, who are willing to part with some stock, can use option premiums to make extra money by selling call contracts for stocks they already own. For example, if you sold an upside call option on a stock you already own, you would be generating income from the premium. But if the stock’s market price moves above the strike price, you would still turn a profit, but you would also have to keep up your part of the bargain and sell that stock to the contract holder.
Let’s say you sold a call option on stock XYZ, a stock you own. The strike price is $25 per share. You’re hoping that the stock price doesn’t move above $25, and you’ll just be able to pocket the premium. But if the market price moves to $30 and the option holder exercises their right to buy stock XYZ, you’ve got to sell the stock.
If you are not a sophisticated investor, trading options with a sustainable amount of success is challenging. But it can be done.
Think of the option premium as a sunk cost. In other words, you will have already incurred this cost, and it can’t be recouped. So when you’re considering whether to exercise your right to buy or sell the underlying asset, the option premium shouldn’t really factor into the equation.
Taking the First Step
Are you feeling ready to start trading options? The first and most important step is always educating yourself, so you’re on the right track!
If you are confident that the price of a stock is poised to head in a certain direction and you’re in a financial position to tolerate the risks associated with options trading, it is possible to generate significant returns on your investment portfolio.If you’re feeling ready to add option contract trading to your portfolio, consider subscribing to Investors Alley’s “Options Floor Trader PRO” newsletter, and we’ll show you how to find and make those trades.