What is an Options Premium?
When you buy an options contract, you get the right (but not obligation) to trade in its underlying security at a specific price and quantity on a certain date. The price paid for this right is called the Options Premium. Hence, it refers to the current market price at which an options contract is valued.
- It is the price that an options buyer has to pay an options seller (a.k.a., options writer).
- Premiums of In the Money (ITM) contracts are influenced by their intrinsic and extrinsic value.
- Premiums of Out of the Money (OTM) contracts are influenced by their extrinsic value. They are said to have no intrinsic value.
- Factors influencing options premiums:
A. Intrinsic Value- This is the difference between the option's strike price and the market/spot price of the underlying
| Call Option | Put Option | |
|---|---|---|
| Intrinsic Value | Market Price of the Underlying - Strike Price | Strike Price - Market Price of the Underlying |
| In the Money (ITM) Contracts | When the strike price is less than the current market price of the underlying. For example, you buy a Tata Motors call option with a strike price of Rs. 490. If the market price of Tata Motors shares is Rs. 500, the contract is said to be ITM with an intrinsic value of Rs. 10. | When the strike price is more than the current market price of the underlying. For example, you buy a Tata Motors put option with a strike price of Rs. 510. If the market price of Tata Motors shares is Rs. 500, the contract is said to be ITM with an intrinsic value of Rs. 10. |
| Out of the Money (OTM) Contracts | When the strike price is more than the current market price of the underlying. For example, you buy a Tata Motors call option with a strike price of Rs. 500. If the market price of Tata Motors shares is Rs. 490, the contract is said to be OTM with no intrinsic value.* * Intrinsic value cannot be negative. | When the strike price is less than the current market price of the underlying. For example, you buy a Tata Motors call option with a strike price of Rs. 500. If the market price of Tata Motors shares is Rs. 510, the contract is said to be OTM with no intrinsic value.* * Intrinsic value cannot be negative |
B. Extrinsic/Time Value- The extrinsic value of an options contract is influenced by time to expiry and Implied Volatility (IV) of the underlying.
The longer an options contract has till its expiry, the greater its time value and hence premium. This is because the holder has more time to exercise the option at a profit.
Implied Volatility (IV) represents the likelihood of a change in the underlying's price. Higher the underlying's IV, the greater the probability of drastic price changes, and hence higher premiums.
As the contract approaches expiry, the time value of a contract (and as a result, its premium) declines due to time decay. Therefore, the influence of extrinsic factors on an options contract's premium (price) decreases over time and becomes negligible by expiry.
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