Option Premium

Key Highlights

• The option premium is the cost paid by an investor to acquire an options contract.

• This premium grants the investor the right, but not the obligation, to buy or sell an underlying asset at a specified strike price before or on a certain date.

What is Option Premium?

The option premium is the cost paid by an investor to acquire an options contract. This premium grants the investor the right, but not the obligation, to buy or sell an underlying asset at a specified strike price before or on a certain date.

Components of Option Premium

The option premium consists of two primary components:

1. Intrinsic Value: The amount by which the current price of the underlying asset exceeds the strike price of the option. If the option is "in the money," this value will be positive.

2. Time Value: The portion of the premium that reflects the time remaining until the option's expiration.

How an Option Premium Works?

• When you buy an option, you pay the writer of the option (the seller) a premium.

• It is that premium which you pay to reserve the option of exercising in the future.

• For example, if you buy a call option to buy a stock for ₹100, the premium is what you pay for that privilege, even if you do not use it. If the option is worthless at expiration (i.e., the stock price doesn't hit your target), you lose the premium but not a penny more.

How to Calculate Option Premium?

Calculating the option premium involves understanding its two main components: intrinsic value and time value. Here's a step-by-step guide to calculating the option premium:

1. Determine the Intrinsic Value

For Call Options: The intrinsic value is the difference between the current price of the underlying asset and the strike price, only if the asset's price is above the strike price. If the asset's price is below the strike price, the intrinsic value is zero.

Formula: Intrinsic Value = Current Asset Price - Strike Price

For Put Options: The intrinsic value is determined by the difference where the strike price is greater than the current price of the underlying asset, relevant only when the asset's price falls below the strike price. If the asset's price is above the strike price, the intrinsic value is zero.

Formula: Intrinsic Value = Strike Price - Current Asset Price

2. Calculate the Time Value

The time value represents the potential for the option to increase in value before expiration. It is calculated by subtracting the intrinsic value from the total option premium.

Formula: Time Value = Option Premium - Intrinsic Value

However, the time value is not directly calculated but is inferred from the market premium after accounting for intrinsic value.

Factors Influencing Option Premium

1. Underlying Asset Price: As the price of the underlying asset fluctuates, so does the premium.

2. Strike Price: The relationship between the strike price and the current market price of the asset significantly impacts the premium.

3. Time to Expiration: Options with more time until expiration typically have higher premiums due to the increased chance of the asset price moving favorably.

4. Volatility: Higher volatility in the underlying asset's price generally leads to a higher option premium, reflecting the increased risk and potential reward.

Option Premium Example

Assuming that you buy a call option on Reliance Industries for a strike price of ₹3,000 with one month of expiration. The option premium is ₹50 per share and each contract requires 100 shares, hence you pay ₹5,000. If Reliance goes up to ₹3,200, you can exercise the option, purchase at ₹3,000, and make a profit (ignoring the premium). If the stock is still below ₹3,000, the option expires, and you lose the ₹5,000 premium—nothing more, nothing less.

Benefits of Option Premiums

• Limited Risk: As a buyer, the premium is the most you can lose if the option does not work out.

• Flexibility: You can make guesses about price movement or hedge yourself against loss without having to use much money.

• Big Potential: A little premium can translate into enormous profit if the market moves in your favor.

Risks to Consider

• Loss of Premium: If the option expires worthless, you forfeit all the premium.

• Complexity: Premiums are hard to predict due to market factors, so you need to keep an eye on things.

• Time Decay: While the date of expiration nears, the premium may decrease if the stock does not move in the way you want.