Option Premium - Meaning, Calculation, Factors and Strategies

What is Option Premium?

Option premium is the amount an option buyer pays to the option seller for the rights to buy and sell an underlying asset. This is the basic option premium meaning.

For a call option, a buyer gets the right to buy the underlying at a strike price. For a put option, a buyer gets the right to sell it at a strike price. A buyer pays the premium for this right.

The premium is quoted as a price per unit of the underlying. The actual amount payable depends on the contract's lot size.

For example, if an option premium is ₹120 and the contract has a lot size of 50 units, the premium payable would be ₹6,000 before applicable charges.
 

How to Calculate Option Premium?

Option premium is usually made up of two components. These components are Intrinsic Value + Time Value. Here is a detailed overview of option premium calculation:

1. Intrinsic Value

Intrinsic value is the profit an option could provide if it were exercised at the current market price. For a call option, you can calculate the intrinsic value using this formula:

Intrinsic Value = Current Price of the Asset − Strike Price

Suppose a stock is currently trading at ₹600, and the strike price of a call option is ₹550.

Intrinsic Value = Current Price − Strike Price

= ₹600 − ₹550

= ₹50

Therefore, the call option has an intrinsic value of ₹50 because the current market price is higher than the strike price.
This applies when the current asset price is higher than its strike price. If the result is negative, you can consider the intrinsic value to be zero.

On the other hand, for a put option, you can calculate it by using this formula: 

Intrinsic Value = Strike Price − Current Price of the Asset

Suppose a stock is currently trading at ₹450, and the strike price of a put option is ₹500.

Intrinsic Value = Strike Price − Current Price

= ₹500 − ₹450

= ₹50

Therefore, the put option has an intrinsic value of ₹50 because the current market price is lower than the strike price.
If the result is negative, the intrinsic value is zero.

2. Time Value

Time value is an additional amount you pay for the possibility that the market may move in favour of the option before expiry. Usually, an option with more time left until expiry has a higher time value. As the expiry date gets closer, this time value tends to decline.

Example of Option Premium Calculation 

Suppose a stock has a strike price of ₹500 and its current market price is ₹530. The option has one month until expiry, and the contract covers 100 shares. Assume the time value is ₹20.

First, we need to calculate the intrinsic value:

Intrinsic Value = Current Market Price − Strike Price

= ₹530 − ₹500 = ₹30

So, the intrinsic value of the option is ₹30.

Now, add the time value to calculate the option premium:

Option Premium = Intrinsic Value + Time Value

= ₹30 + ₹20 = ₹50 per share

Since the contract covers 100 shares, the total premium would be:

₹50 × 100 = ₹5,000

With this calculation, we can see that the option premium is ₹50 per share, or ₹5,000 for the entire contract. This example shows how the intrinsic value and time value together make up the option premium.

What are the Factors that Impact Premium in Option Trading?

There are several variables which affect an option's premium. These include intrinsic value, time value, implied volatility, time until expiration, and many others. Here is a detailed understanding of what are the key aspects which affect the option premium:

1. Intrinsic Value

Intrinsic value depends on the relationship between the underlying price and the strike price. A call option generally has intrinsic value when the underlying price is above the strike price. A put option has intrinsic value when the underlying price is below the strike price.

2. Time Value

Time value shows the possibility that an option could gain intrinsic value before expiry. More time before expiry generally gives the option more opportunity to move into the money. This can support a higher premium, although other factors also matter.

3. Implied Volatility

Implied volatility shows you the market's expectation of future price fluctuations. Higher implied volatility can increase option premiums. On the other hand, lower implied volatility can reduce them.

4. In-the-Money Status

An option can be in-the-money, at-the-money or out-of-the-money. For example, a call with a strike price below the current market price is in-the-money. A put with a strike price above the market price is in-the-money. ITM options generally contain intrinsic value. OTM options do not.

5. Time Until Expiration

The expiry date has a direct relationship with an option's time value. An option with 30 days left and another with 3 days left can therefore have very different premiums.

6. Interest Rates

Interest rates can influence option pricing because they affect the present value of the strike price. The impact of interest rates is usually less visible than factors such as the underlying price and implied volatility.

How to Use Option Premium in Trading Strategy?

Option premium trading involves buying or selling options based on the terms and market price of the contract. Here is a detailed overview:

1. Buying Options

When you buy an option, you pay the option premium upfront. A call option gives the buyer the right to buy the underlying asset at the strike price. On the other hand, a put option gives the right to sell it.

For example, you may buy a call option when you expect the underlying price to increase. Also, you may buy a put option when you expect the underlying price to fall. If you are an option buyer, the premium you pay is generally the maximum amount at risk if the option expires worthless.

2. Selling Options

When you sell an option, you receive the premium from the buyer. However, this premium comes with an obligation under the contract.

The potential loss for an option seller can be substantial. For an uncovered (naked) call seller, loss is theoretically unlimited. For an uncovered put seller, the maximum loss occurs if the underlying stock drops to zero, making the maximum risk equal to:

Strike Price - Premium Received x Lot Size

Final Word

Option premium is the price attached to an options contract. Its value is influenced by intrinsic value, time value, implied volatility, the underlying price, interest rates, dividends and time to expiry. Understanding these components can make it easier to read an option chain and interpret premium movements.

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