Option Premium

[Igor 10]

An option premium is the amount that a buyer pays or the seller receives for one option contract. Premium values fluctuate throughout the life of the contract and reach zero after the option expires. The fluctuation depends on how close the option's strike price is to the underlying asset's market price, and how close an option is to expiring. Traders calculate premiums by adding the option's intrinsic value to its time value.

 

Option Premium for Buyers

Premiums determine how much a buyer will pay for one option contract. The premium's function works the same for both call and put buying, and its cost reduces the amount of profit taken from exercised options in-the-money (ITM). For options that expire out-of-the money (OTM), the total premium costs will equal the total amount the buyer will lose on their investment.

 

Example:

1) Buyer purchases one put option: GEJan20($2) = 100 shares of GE stock at $20/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $2.

 

2) Buyer pays $200 (100 (shares) x $2 (premium cost)).

Result one (ITM): GE hits $10. The put buyer buys 100 shares at the market price for $1,000. Then, they exercise their right to sell the 100 shares at $20 for $2000. Their total profit is $1,000. The premium costs cut their profit to $800 profit after subtracting the $200 they paid to enter the market.

 

Result Two (OTM): GE hits $30. The put option buyer lets the contract expire, does not exercise their right to sell and loses the amount of premiums paid. In this example, the put buyer would lose a total of $200.

 

Option Premium for Sellers

Sellers use premiums to find the amount they will receive for one option contract. The premium's function works the same for both call and put selling. For options that settle ITM, premium costs will equal the total amount the seller will gain on their investment. For options that expire OTM, premium costs will reduce the amount the seller will lose on their investment.

 

Example:

1) Seller writes one put option: GEJan20($2) = 100 shares of GE stock at $20/per share(strike price), expiring on 1/15 (strike date) with a premium cost of $2.

 

2) Seller receives $200 (100 (shares) x $2 (premium cost)).

 

Result one (OTM): GE hits $10. Put buyer exercises the option and obligates the seller to buy 100 shares at $20, so they pay $2000 for stock worth $1000. The put seller loses $800 after adding premiums.

 

Result Two (ITM): GE hits $30. The put option buyer lets the contract expire. In this example, the put option seller would gain $200 from premiums collected.

 

Intrinsic value

This value is simply the difference between the market price and the strike price. A call's strike price that exceeds its market price has no intrinsic value.

 

Example:

1) Underlying asset: GE currently trading at $20

a) Call Option 1: GEA18, strike price at $18 has an intrinsic value of $2 ($20-$18)

b) Call Option 2: GEA22, strike price at $22 has -($2) or $0 intrinsic value ($20-$22)

 

Time Value

Simply put, options are a dying asset, meaning that its value slowly decreases starting from the moment it enters the market. Trading experts call this occurrence time decay. The closer a $0 intrinsic value option gets to its expiration date, the less it is worth. Investors calculate time value by subtracting the option's trading price from its intrinsic value. Time value is equal to an option's price when it has no intrinsic value.

 

Example:

1) Underlying asset: GE currently trading at $20

a) Call Option 1: GEA18 trading at $3.50, strike price at $18

 

Result: This option has an intrinsic value of $2 and a time value $1.50 ($3.50-$2.00). Its premium cost is $3.50. b) Call Option 2: GEA22 trading at $.75, strike price at $22

 

Result: This option has an intrinsic value of $0 and time value $.75 ($0.75-$0). Its premium cost is $.75.

 

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