Option Premium

The premium is the price of an option: what the buyer pays and the seller receives. It is quoted per unit of the underlying, so a US stock option quoted at $2.40 costs $240 for one contract of 100 shares. The premium is not arbitrary. It reflects the value of the right the option gives, which depends on where the underlying is, where the strike is, how much time is left and how much the underlying is expected to move.

The two parts of the premium#

premium = intrinsic value + extrinsic value

• Intrinsic value: what the option would be worth if exercised right now. For a call, the underlying price minus the strike (if positive); for a put, the strike minus the underlying price (if positive).
• Extrinsic value (time value): everything else, the price of time and uncertainty.

See Intrinsic and Extrinsic Value.

What drives the premium#

The Greeks measure how much the premium changes when each factor changes. See The Option Greeks Explained.

Volatility: the hidden driver#

Of all the inputs, only implied volatility cannot be observed directly. It is the market's estimate of how much the underlying will move, backed out from option prices. When traders expect big moves, such as before earnings, implied volatility and premiums rise. After the event, they often fall sharply, which is called volatility crush. See Implied Volatility (IV) and Volatility Crush and Expansion.

Pricing models#

Option prices are usually calculated with models. The Black Scholes model, published in 1973, gives a formula for European options based on the underlying price, strike, time, volatility and interest rates. Binomial trees handle American options that can be exercised early. See Black-Scholes Model and Binomial and Trinomial Trees.

Bid, ask and mid#

Options have a bid and an ask like any market. Spreads can be wide, especially for far out of the money strikes, distant expirations or less active underlyings. Buying at the ask and selling at the bid can cost a large share of the premium.

• Use limit orders near the midpoint rather than market orders. See Limit Orders.
• Prefer liquid options with high volume and open interest. See Options Open Interest Analysis.

Premium for buyers and sellers#

• Buyers pay the premium and need the option to gain enough value to cover it. Time decay works against them.
• Sellers collect the premium and profit if the option loses value. Time decay works for them, but they carry the risk of large moves.

Selling premium tends to win often with occasional large losses; buying premium tends to lose often with occasional large wins. See Theta Harvesting.

Common mistakes#

• Judging options as cheap or expensive by dollar price instead of by implied volatility.
• Ignoring the spread on illiquid options.
• Buying options right before events without considering volatility crush.

Frequently asked questions#

What is an option premium?#

The price paid by the buyer to the seller for an option contract, quoted per unit of the underlying.

What affects the price of an option?#

The underlying price, strike price, time to expiration, implied volatility, interest rates and dividends.

Why do option premiums rise before earnings?#

Because traders expect bigger price moves, which raises implied volatility and therefore option prices.

Next, learn how expiration dates work in Option Expiration Dates.