What Is Option Premium? Pricing Factors and Examples Explained

What Is an Option Premium?

An option premium is the current market price of an option contract, which is the choice to buy or sell an underlying asset later, at an agreed-upon price. It is, therefore, the income that the seller (writer) of an option contract receives from another party.

Investors and traders will either pay or receive options premiums, which are affected by intrinsic and extrinsic values, market volatility, and expiration dates. Learn more about the factors that influence options premiums to help your understanding of trading options contracts.

How Option Premiums Work

Investors who write calls or puts, which means to sell in this case, use option premiums as a source of current income in line with a broader investment strategy to hedge all or a portion of a portfolio. Option prices on exchanges like the Cboe Options Exchange (Cboe) are seen as premiums because options have no intrinsic value.

An option premium includes intrinsic value, its time value, and the implied volatility of the asset. As the option nears its expiration date, the time value will edge closer and closer to $0, while the intrinsic value will closely represent the difference between the underlying security's price and the strike price of the contract.

Key Factors That Influence Option Premium Pricing

An option's price is affected by the security's price, moneyness, time to expiration, and implied volatility. The option premium changes as the underlying security's price changes. As the underlying security's price increases, the premium of a call option increases, but the premium of a put option decreases. As the underlying security's price decreases, the premium of a put option increases, and the opposite is true for call options.

The moneyness affects the option's premium because it indicates how far away the underlying security price is from the specified strike price. As the option becomes further in the money, the option's premium normally increases. Conversely, the option premium decreases as the option becomes further out of the money. For example, as an option becomes further out of the money, the option premium loses intrinsic value, and the value stems primarily from the time value.

The time until expiration, or the useful life, affects the time value portion of the option's premium. As the option approaches its expiration date, the option's premium stems mainly from the intrinsic value. For example, deep out-of-the-money options that are expiring in one trading day would normally be worth $0, or very close to $0.

The Role of Implied Volatility in Option Pricing

Implied volatility is derived from the option's price, which is plugged into an option's pricing model to indicate how volatile a stock's price may be in the future. Moreover, it affects the extrinsic value portion of option premiums. If investors are long options, an increase in implied volatility would add to the value. This is because the greater the volatility of the underlying asset, the greater the chances the option has of finishing in the money. The opposite is true if implied volatility decreases.

For example, consider an investor holding a call option with an implied volatility of 20%. Therefore, if the implied volatility increases to 50% during the option's life, the call option premium would appreciate in value. An option's vega is its change in premium given a 1% change in implied volatility.

The Bottom Line

An option premium is the price paid for the right to buy or sell an asset at a specified price before a certain date. Option premiums are composed of intrinsic and extrinsic values, which are influenced by time to expiration and implied volatility. Factors that affect premiums are underlying asset prices, moneyness, time value, and implied volatility.

Understanding these factors empowers investors to make informed decisions and effectively utilize options for strategies such as hedging or income generation. Options can be complex concepts, so it's best to consult professionals and take the time to learn as much as possible about them before trading.