What is an Option Premium?

In the derivatives market, one of the core concepts is the option premium. It refers to the amount paid by the buyer to the seller to acquire rights under an options contract. This article outlines what the option premium is, how it is determined, and its relevance for both option buyers and sellers.

Contents

• What Is an Option Premium?
• Components of Option Premium
• Factors That Influence Option Premium
• Option Premium: Buyer vs. Seller Perspective
• Conclusion
• FAQs

What is an Option Premium?

An option premium is the sum the buyer pays to the seller to obtain the rights granted under the option contract. Usually stated for one contract, this figure is calculated per share and covers 100 shares.

Consider the premium on the price of holding the option. For the buyer, it is the cost of protection or leverage. For the seller, it’s compensation for assuming the risk.

Read Also:How To Trade In Options With Small Capital

Components of Option Premium

The total premium comprises two core elements: Intrinsic Value and Time Value.

1. Intrinsic Value

The intrinsic value of an option reflects how much it is currently in-the-money (ITM):

• For a call option, this is the amount by which the market price exceeds the strike price.
• For a put option, it is the amount by which the strike price exceeds the market price.
• Only ITM options have intrinsic value. For out-of-the-money (OTM) or at-the-money (ATM) options, intrinsic value is zero.

Formula:

• Call Option: Intrinsic Value = Current Market Price – Strike Price
• Put Option: Intrinsic Value = Strike Price – Current Market Price

2. Time Value

The time value is the difference between the total premium and the intrinsic value. It represents the potential for the option to become profitable before expiry. Time value reduces over time, known as time decay.

Formula:

Time Value = Option Premium – Intrinsic ValueIntrinsic value reflects how much an option is currently in-the-money (ITM).

Factors that Affect Option Premium

Many elements decide how high or low an option’s premium is:

1. Underlying Asset Price

The closer the market price is to the strike price, the more sensitive the premium becomes. A movement toward ITM increases the premium.

2. Strike Price:

ATM options typically have higher time value. Options far ITM or OTM may have lower premiums.

3. Time to Expiry:

More time to expiry typically results in a higher premium due to greater uncertainty.

4. Market Volatility:

Higher implied volatility raises the premium due to greater expected price fluctuation in the underlying.

5. Interest Rates and Dividends:

Expected dividend payments and interest rate changes (such as RBI announcements) can impact premiums, especially for longer-term contracts.

Option Premium: Buyer’s vs. Seller’s Prospective

From the Buyer’s Perspective:

• The premium is the upfront cost to acquire option rights.
• Defines the maximum potential loss.
• Allows access to leveraged market exposure with defined risk.

From the Seller’s Perspective:

• The premium is income for assuming a potential obligation.
• The seller may be obligated to deliver (calls) or purchase (puts) the underlying asset if the contract is exercised.
• Risk may be high if the position is uncovered (e.g., selling naked options).

Read Also:Understanding Lot Sizes, Expiry, and Strike Prices in Options Trading

Conclusion:

The option premium represents the cost of acquiring an options contract and reflects a combination of intrinsic value, time value, and market expectations. Understanding its calculation and influencing factors helps market participants evaluate their positions with more clarity.

Disclaimer: This article is for educational purposes only and does not constitute investment advice. Options trading involves significant risk and is not suitable for all investors. Please consult a SEBI-registered financial advisor to assess your individual risk capacity before participating in derivatives markets.

FAQs