What is Option Premium? Meaning, Example & Pricing Formula

What is Option Premium?

At its core, an option premium is the price a buyer pays to acquire an option contract. This premium is not a deposit or margin; it's a non-refundable fee paid upfront. For the seller, it represents the income or credit received for taking on the potential obligation.

To understand option premium meaning clearly: if you buy a call or put option, you're purchasing the right (but not the obligation) to buy or sell the underlying asset at a predetermined price (the strike price) within a specified time. In exchange for that right, you pay the premium.

For example, if you buy a call option on a stock at ₹100 with a premium of ₹5, you pay ₹5 per share, regardless of whether you eventually exercise the option or not. This makes the option premium example easier to visualise: if the stock rises to ₹120 before expiry, the option gains in value, but the ₹5 paid remains your initial cost.
 

Factors Affecting Option Premium Calculation

Several variables influence how is option premium calculated. Unlike a fixed price tag, the premium fluctuates constantly based on market dynamics. These are the main factors that contribute to it:

1. Intrinsic Value
This is the real, measurable value of the option if exercised today. For a call option, it's the difference between the current market price and the strike price, provided the option is in-the-money (ITM). For put options, it's the reverse. Out-of-the-money (OTM) and at-the-money (ATM) options have zero intrinsic value.

2. Time Value
Time value reflects the potential for an option to gain intrinsic value before it expires. The more time remaining, the higher this component tends to be. This explains why options with longer expiries generally have higher premiums.

3. Volatility
Volatility, particularly implied volatility, plays a crucial role. When a stock is more volatile, there's a greater chance the option might end up ITM before expiry. Hence, high premium options often belong to stocks with high expected price swings.

4. Interest Rates
Changes in interest rates also influence premiums, though their impact is generally modest for short-term contracts. A rise in rates tends to slightly increase call premiums and reduce put premiums.

5. Dividends
Expected dividends affect call and put premiums differently. If a stock is expected to pay dividends before expiry, call options may see a reduction in premium due to the drop in the stock price post-dividend.
 

How the Black-Scholes Model Helps Price Options

To bring consistency and structure to option premium calculation, models like Black-Scholes are widely used, especially for European options.

The option premium formula in the Black-Scholes Model uses:

• Current stock price (S)
• Strike price (K)
• Time to expiry (T)
• Risk-free interest rate (r)
• Volatility (σ)

The model assumes a log-normal distribution of stock prices and no early exercise, making it more suitable for European-style options than American ones.

For example, using the model, if a stock trades at ₹200 with a strike of ₹210, 30 days to expiry, and implied volatility of 25%, the resulting call premium might be ₹6. This doesn’t just reflect the difference in stock and strike price, but also the probability that the stock might cross ₹210 within that time, accounting for volatility and time value.
 

Strike Price vs Option Premium

There’s a direct relationship between the strike price of an option and its premium. Options that are in-the-money (ITM) have higher premiums due to both intrinsic and time value. At-the-money (ATM) options generally have no intrinsic value but can still command a high premium if the stock is volatile or the expiry is far away. Out-of-the-money (OTM) options have only time value, and their premium is typically lower.

This is why premium stock options often come with either deep ITM characteristics or high implied volatility, making them appealing to sellers aiming to earn more income upfront, but riskier for buyers if the move doesn’t materialise.
 

Conclusion

Understanding the option premium meaning goes beyond just knowing it’s the cost of entering a contract. It involves evaluating the market forces, probabilities, and time sensitivity that drive the value of options. Traders who comprehend how is option premium calculated can assess whether an option is fairly priced and decide on strategies accordingly.

Whether you're a buyer aiming to limit downside or a seller hoping to profit from high premium options, grasping this concept gives you an edge.

As option markets evolve, being well-versed in calculating premium on options will continue to be an essential aspect of any successful trading approach.