Options are derivatives that are financial instruments whose price is based on the value of the underlying security such as stocks. Options are of two types call and put option. The call option gives the buyer the right to buy but not the obligation and the put option gives the buyer the right to sell but not the obligation. Each option contract has an expiration date which signifies that when the option holder must exercise the option. The price that is predetermined is known as the strike price. The individual or entity who sells the option is known as an option writer who has an obligation to perform the contract if the buyer chooses to exercise the option by having the right to buy or sell.
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What is an option premium?
Options premium is the current market price the buyer pays the seller for the option. It is the amount that is paid upfront and non-refundable even if the options Are not exercised. For stock options, the premium is quoted as a dollar per amount per share and most contracts represent the commitment of 100 shares. Thus, a premium of $0.15 represents a premium payment of $15.00 per option contract ($0.15 x 100 shares).
Factors considered in Option Premium:
- Intrinsic value: Intrinsic value is the difference between the strike of the option price(X) and the current price of the underlying security in the market.
For call options,
INTRINSIC VALUE = STOCK PRICE – STRIKE PRICE (X)
For put options,
INTRINSIC VALUE = STRIKE PRICE (X) – STOCK PRICE
It is the value any given option would if it were exercised today. The intrinsic value of an option gives an effective advantage resulting from the immediate exercise of that option. It is the minimum value of the option. Options that trade at the money or out of the money have no intrinsic value.
- Time value: Time value is the difference between the option price and the intrinsic value.
TIME VALUE = OPTION PRICE – INTRINSIC VALUE
In other words, it can be said that time value is the amount that is left after calculating the profit between the strike price and the stock price in the market. This results in time value being referred to as the extrinsic value as time value is the amount by which the price of the option exceeds the intrinsic value.
How it is calculated?
The premium of the option is calculated by adding the intrinsic value, time value, and volatility (if the underlying asset is volatile, there would be an added amount to the premium)-
PREMIUM = INTRINSIC VALUE + TIME VALUE
If a call option has an intrinsic value of $20 and a time value of $10 so an entity or individual will have to pay $30 to buy the option. The strike price is $70 which is pre-decided. The option holder will have a break-even point of $100(premium + strike price). This means that only if the price of the underlying asset in the market goes above the $100 will the option holder earn a profit by exercising the option. To compensate for the premium amount the option holder would only like to exercise the option if the price crosses the break-even point.
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Factors that affect option premium:
- Underlying asset price: The price of the underlying asset can increase or decrease the value of the option. If the price of the underlying security rises the value of the call options will increase but the value of the put option will decrease.
- Strike price: The strike price will determine if the option has an intrinsic value. The premium of the option will increase as the option becomes further in-the-money and decrease as the option deeply becomes out-of-the-money.
- Time until expiration: Time until expiration affects the time value of the premium of an option. As the maturity approaches the level of an option’s time value decrease for both a call and put option.
- Implied volatility: Volatility is considered a friend of the option. High volatility means higher fluctuations of the price of the underlying asset. This results in a higher option premium for call and puts options. It will be most noticeable in at-the-money options.
- Dividend and the risk-free rate: Cash dividends affect options prices through their effect on the underlying stock price. High cash dividends usually lower call premiums and higher put premiums. An increase in interest rates will increase the call premiums and cause put premiums to decrease. After considering all the factors that affect the premium of the option will allow the investor to differentiate from a reasonable and unreasonable option and this understanding will have big chances of getting a big return from the option.
Author -Sanjana Rau
About the Author- Started my journey of self even when the odds were against me, keen observation, a cool temper, and sports worked the best for me.