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Option Premium: A Complete Guide for Beginners

Views 1502Jul 8, 2024

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.

understand the premium

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.

what is premium

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.

commission-free options trading on moomoo

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: Navigate to your Watchlist, then select a stock's "Detailed Quotes" page.

moomoo app watchlist

Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.

Step 2: Navigate to Options> Chain located at the top of the page.

Step 3: By default, all options with a specific expiration date are shown. For selective viewing of calls or puts, simply tap "Call/Put."

moomoo app options tab

Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.

Step 4: Adjust the expiration date by choosing your preferred date from the menu.

select expiration date

Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.

Step 5: Easily distinguish between options: white denotes out-of-the-money, and blue indicates in-the-money. Swipe horizontally to access additional option details.

confirm the moneyness

Disclaimer: Images provided are not current and any securities are shown for illustrative purposes only and is not a recommendation.

Step 6: Explore various trading strategies at the screen's bottom, offering flexibility for your investment approach.

switch between different options 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.

This feature is for educational use only. Options trading is very risky and is not appropriate for all customers. Read the Characteristics and Risks of Standardized Options before trading options.

This feature is not a recommendation or endorsement of any particular investment or investment strategy. Investment information provided in this content is general in nature, strictly for illustrative purposes, and may not be appropriate for all investors. It is provided without respect to individual investors’ financial sophistication, financial situation, investment objectives, investing time horizon, or risk tolerance. Options transactions are often complex and may involve the potential of losing the entire investment in a relatively short period of time. Certain complex options strategies carry additional risk, including the potential for losses that may exceed the original investment amount. Supporting documentation for any claims, if applicable, will be furnished upon request.

Moomoo does not guarantee favorable investment outcomes. The past performance of a security or financial product does not guarantee future results or returns. Customers should consider their investment objectives and risks carefully before investing in options. Because of the importance of tax considerations to all options transactions, the customer considering options should consult their tax advisor as to how taxes affect the outcome of each options strategy.

Moomoo is a financial information and trading app offered by Moomoo Technologies Inc. In the U.S., investment products and services on Moomoo are offered by Moomoo Financial Inc., Member FINRA/SIPC. In Singapore, investment products and services available through the moomoo app are offered through Moomoo Financial Singapore Pte. Ltd. regulated by the Monetary Authority of Singapore (MAS). Moomoo Financial Singapore Pte. Ltd. is a Capital Markets Services Licence (License No. CMS101000) holder with the Exempt Financial Adviser Status. This advertisement has not been reviewed by the Monetary Authority of Singapore.In Canada, order-execution only services available through Moomoo are provided by Moomoo Financial Canada Inc., regulated by the Canadian Investment Regulatory Organization (CIRO). In Australia, financial services available through the Moomoo App are provided by Moomoo Securities Australia Limited regulated by the Australian Securities and Investment Commission (AFSL 224663).

In Malaysia, investment products and services available through the moomoo app are offered through Moomoo Securities Malaysia Sdn. Bhd. ("Moomoo MY") regulated by the Securities Commission of Malaysia (SC).  Moomoo Securities Malaysia Sdn. Bhd. is a Capital Markets Services Licence (License No. eCMSL/A0397/2024) holder. This advertisement has not been reviewed by the SC.

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