Definition of an Option’s Premium
Investopedia says that “an option premium is the income received by an investor who sells or “writes” an option contract to another party.” Premium may also refer to the current price of an option contract that has yet to expire. In simple terms, it is the price of an options contract. An option’s unit of trading or contract size is usually 100 shares of the underlying security, therefore if an option is trading for $5, the aggregate premium would be $500. The OCC, in “The Characteristics and Risks of Standardized Options,” defines premium as “the price that the holder of an option pays and the writer of an option receives for the rights conveyed by the option.” The payment goes from the option holder to the option writer.
Components of an Option’s Premium
- Intrinsic Value – Reflects the amount, if any, by which an option is in the money.
- Time Value – Whatever the premium of the option value is less the intrinsic value.
A Review of Intrinsic Value and Time Value
In order to more firmly understand intrinsic value, we have to go back to the basics of calls and puts. A call option is in the money when the exercise price is less than the market price (i.e. option holder can purchase stock below market price). A put option is in the money when the exercise price is Exercise price greater than the market price (i.e. option holder can sell stock above market price).
Here is a graphic that can help visualize these characteristics:
If a call is in the money, intrinsic value is calculated as follows:
Intrinsic value = Current stock (market) price – exercise price
If a put is in the money, intrinsic value is calculated as follows:
Intrinsic value = exercise price – current stock (market) price
Time value is derived as follows:
Time value = premium – intrinsic value.
Put another way, as per the OIC, “time value is any premium in excess of the intrinsic value before expiration. Time value is often explained as the amount an investor is willing to pay for the option above its intrinsic value.”
What Influences an Option’s Premium?
There are numerous factors which influence the premium of an option. These include:
- Changes in the current value of the underlying stock.
- As stock price rises, the premium of a call will increase, the premium of a put will decrease
- As stock price decreases, the premium of a call will decrease, the premium of a put will increase.
The below table summarizes this relationship
|Call option premium||Put option premium|
|Stock price increases||Increases||Decreases|
|Stock price decreases||Decreases||Increases|
Other factors that influence the premium of an option are
- Strike price
- Time until expiration – for both puts and calls, time value decreases as the option nears expiration
- The volatility of the underlying stock
- Other factors such as cash dividends payable on the underlying stock, interest rates, currency exchange rates, the depth of the market for the option, and estimates of future developments that may affect stock price.
How is Premium Paid Out?
Premium is paid from the option buyer (i.e. the option holder) to the option seller (i.e. the option writer). As an option buyer, you are said to pay a debit to the option writer. As an option writer, you are said to receive a credit from the option buyer.
The Role of the Options Clearing Corporation
According to its 2017 annual report, the OCC is “the world’s largest clearing organization for equity derivatives.” The OCC issues, guarantees, and clears all option contracts. In a nutshell, the OCC is responsible for the system that backs the performance of options.