Option Premium: A Complete Guide for Beginners
The option premium is a crucial concept in options trading, representing the price paid by the buyer to the seller for the right, but not the obligation, to buy or sell an underlying asset at a predetermined price within a specified period. Understanding option premiums is essential for anyone venturing into options trading. This comprehensive guide breaks down the intricacies of option premium, its components, and factors influencing its value.
What is an option premium
In options trading, the premium of an option is the price paid by the buyer to the seller for the rights conveyed by the options contract. This price reflects the combined intrinsic value and time value of the option, both of which contribute to its overall worth. Each options contract typically represents 100 shares of the underlying asset.
The premium is essential as it determines the cost basis and potential profit or loss for the buyer and seller of the option. Understanding the components and determinants of option premiums is crucial for making informed trading decisions in the options market.
Factors affecting option premium
Intrinsic value
Intrinsic value is the portion of the option premium that relates to the underlying asset's real value in the market. It is determined by the difference between the current market price of the underlying asset and the option's strike price; an option only has intrinsic value if it is in-the-money. For example, if a call option has a strike price of $50 and the underlying stock is trading at $60, the intrinsic value would be $10 per share.
Time value
Time value represents the premium amount that exceeds the option's intrinsic value and is attributable to the time remaining until the option's expiration. As expiration approaches, the time value tends to diminish due to the decreasing probability of the option being profitable.
For example, consider two call options on the same underlying stock with the same strike price. One option has three months until expiration, while the other option has six months until expiration. All else being equal, the option with six months until expiration would have a higher time value because it has more time for the underlying stock to potentially move, increasing or decreasing in value before expiration.
Volatility
Volatility measures the degree of fluctuation in the price of the underlying asset. Higher volatility tends to increase option premiums as it enhances the likelihood of the option reaching its strike price before expiration; however, the market could move away and the option may not reach its strike price before expiration. Conversely, lower volatility reduces option premiums due to decreased potential for significant price movements.
For example, consider two options on different underlying stocks with the same strike price and expiration date. If one stock experiences higher volatility due to factors such as earnings announcements or geopolitical events, its option premium would likely be higher compared to the option on the less volatile stock.
Dividends
Dividends can impact option premiums, particularly for options on dividend-paying stocks. The ex-dividend date, which marks the cutoff point for eligibility to receive dividends, can influence option prices. Call options may see a decrease in premium leading up to the ex-dividend date due to the anticipated drop in the stock's price after dividends are paid out, while put options may experience an increase in premium.
For example, suppose a stock is trading at $100 per share, and the company announces a $2 dividend. On the ex-dividend date, the stock price is expected to drop by $2 to $98. This decrease in the stock price would likely result in lower call option premiums and higher put option premiums leading up to the ex-dividend date.
Difference between strike price and option premium
Strike Price | Option Premium | |
Definition | The predetermined price at which the underlying asset can be bought or sold upon exercising the contract | The price paid by the option buyer to the seller for the rights conveyed by the options contract The price received by the seller from the option buyer |
Determinants | Fixed at the initiation of the options contract | Influenced by factors such as intrinsic value, time value, volatility, and dividends |
Impact on profitability | Determines the breakeven point for the option trade | Contributes directly to the cost basis or potential profit/loss of the option trade |
How to trade options using Moomoo
Moomoo provides a user-friendly platform for trading options. Here's a step-by-step guide:
Step 1: Go to your Watchlist, then select a stock's "Detailed Quotes" page.
Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 2: Tap Options> Chain on top of the page
Step 3: All options with a particular expiration date are displayed by default. To view only calls or puts, tap "Call/Put."
Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 4: Switch to a different expiration date by selecting the desired date.
Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 5: Out-of-the-money options are displayed in white, while in-the-money options are displayed in blue. Scroll horizontally to view more information about the available options.
Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
Step 6: At the bottom of the screen, you can switch between different trading strategies.
Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.
FAQs about option premium
Is the option premium paid per share?
Yes, the option premium is paid on a per-share basis. When trading options, the premium quoted is typically on a per-share basis, with each options contract representing 100 shares of the underlying asset. For example, if the premium for a call option is $2.50, the total cost of purchasing one options contract would be $250 (calculated as $2.50 per share x 100 shares per contract).
How is the option premium calculated?
The calculation of option premium involves several factors, including intrinsic value, time value, volatility, interest rates (slight impact on extrinsic value) and dividends.
Intrinsic value: Determined by the difference, if in the money, between the current market price of the underlying asset and the option's strike price.
Time value: Reflects the amount by which the option's premium exceeds its intrinsic value; it usually diminishes as the option approaches expiration.
Volatility: Measures the magnitude of price fluctuations in the underlying asset, which also influences the option premium.
Additionally, dividends can impact option premiums, particularly for options on dividend-paying stocks. Various mathematical models, such as the Black-Scholes model, are used to calculate option premiums based on these factors.
What is a net option premium?
The net option premium refers to the total cost or proceeds of an options trade, considering both the premium paid or received and any associated transaction fees or commissions. Note that multi-leg option trades need to take into account the premium for each option contract involved. For buyers of options, the net premium paid is the sum of the option premium and any fees incurred.
Conversely, for sellers of options, the net premium received is the option premium minus any transaction fees or commissions. Understanding the net option premium is important for assessing the true cost or profit potential of an options trade after accounting for all expenses.