What is Option Premium in Stock Market

 option premium is the price that a buyer pays to the seller to acquire the rights that an options contract provides. This price is determined by several factors and reflects the value of the option in the market.

Components of the Option Premium

  1. Intrinsic Value

    • Definition: The intrinsic value is the amount by which an option is in-the-money (ITM). For a call option, it is the difference between the underlying asset's current price and the strike price (if the asset's price is above the strike price). For a put option, it is the difference between the strike price and the underlying asset's current price (if the asset's price is below the strike price).
    • Formula:
      • Call Option: Intrinsic Value=max⁡(0,Current Price−Strike Price)\text{Intrinsic Value} = \max(0, \text{Current Price} - \text{Strike Price})
      • Put Option: Intrinsic Value=max⁡(0,Strike Price−Current Price)\text{Intrinsic Value} = \max(0, \text{Strike Price} - \text{Current Price})

  2. Extrinsic Value (Time Value)

    • Definition: The extrinsic value, also known as time value, is the portion of the option premium that exceeds the intrinsic value. It accounts for the possibility of the option increasing in value before expiration.
    • Factors Influencing Extrinsic Value:
      • Time to Expiration: More time until the option expires generally increases the time value because there's more opportunity for the option to become profitable.
      • Implied Volatility: Higher volatility increases the likelihood of larger price swings, which can increase the time value.
      • Interest Rates: Higher interest rates can increase the time value, particularly for call options.
      • Dividends: Expected dividends can affect the time value of options, especially for stocks.

Example of Option Premium Calculation

Consider a call option on a stock with the following details:

  • Current Stock Price: $150
  • Strike Price: $140
  • Time to Expiration: 30 days
  • Implied Volatility: 20%

Assume the option premium is $15. This premium consists of both intrinsic and extrinsic values:

  • Intrinsic Value: $150 - $140 = $10
  • Extrinsic Value: $15 - $10 = $5

So, in this example:

  • Option Premium: $15
    • Intrinsic Value: $10
    • Extrinsic Value: $5

Factors Affecting Option Premium

  1. Underlying Asset Price: Changes in the price of the underlying asset directly affect the intrinsic value of the option.
  2. Strike Price: The intrinsic value is calculated based on the difference between the strike price and the current price of the underlying asset.
  3. Time to Expiration: Options with more time until expiration typically have higher premiums due to higher time value.
  4. Implied Volatility: Higher implied volatility increases the likelihood of the underlying asset’s price moving significantly, raising the option’s premium.
  5. Interest Rates: Changes in interest rates can affect the cost of carrying the underlying asset, influencing the option premium.
  6. Dividends: Expected dividend payments can affect the price of call and put options, especially for stock options.

Practical Use of Option Premium

  • Buying Options: When you buy an option, the premium is the price you pay to gain the right to buy (call option) or sell (put option) the underlying asset at the strike price.
  • Selling (Writing) Options: When you sell an option, you receive the premium as compensation for taking on the obligation to buy or sell the underlying asset if the option is exercised.
  • Hedging: Investors may use options and their premiums to hedge against potential losses in their portfolios.
  • Speculation: Traders use options to speculate on the future direction of the underlying asset's price, using the premium as a cost of this speculative position.