Premium is the price that a trader buys or sells an options contract for. It is determined by a variety of factors, including:
-- The intrinsic value of the option. When an option is in the money, the intrinsic value is the difference between the market price of the underlying security and the option's strike price. When an option is out of the money, the intrinsic value is $0.
-- The time value of the option. Time value decreases as the expiration date nears because there is less time for the intrinsic value to increase. Time value reaches $0 on the option's expiration date.
-- The implied volatility of the option. The portion of the premium associated with the implied volatility will increase as the volatility of the underlying security increases, because the chance of reaching the strike price is higher for more volatile securities.
There are several formulas that are used to determine what the premium of an option should be. The Black-Scholes formula is among the best known, and its importance has been recognized with a Nobel Prize in Economics.
In the most simplified terms, the premium can be found with an equation that considers several factors:
Premium = Intrinsic Value + Time Value + Implied Volatility
To find the intrinsic value of the option, find the difference between the market price of the underlying security and the option's strike price. For a call option, subtract the strike price from the current market price of the underlying security. For example, a call with a strike price of $10 on a stock with a market price of $15 has $5 of intrinsic value. For a put option, subtract the market price of the underlying security from the strike price. A put with a $12 strike price on a stock with a market price of $9 has $3 of intrinsic value. Again, the intrinsic value for out-of-the-money options is $0.
Determining the time value and implied volatility is more difficult. There are a number of calculators available on different websites and in software packages that can do this.
How Traders Use It
Premium is used to determine the potential profits on a trade.
When buying options, most traders begin their analysis by finding securities they expect to see large price moves in. They will then review the available options contracts on that security, comparing the actual premiums to what they believe the premiums should be. Like investing in stocks, value is an important consideration, and buying undervalued options would be preferable to buying overvalued options.
Traders will then determine what the premium is expected to be when they close the trade. They will calculate the expected profit and consider the risk of the trade, which is limited to the premium paid per contract when they are buying options. Successful traders usually pick the trades with the best reward-to-risk ratio, based on the premium and expected premium.
When selling options, the premium is the amount the seller is paid for accepting the potential obligation of having to buy or sell the underlying stock at the option's strike price. Many options sellers look for overpriced options to sell to increase the amount of income they can generate with this strategy. If the option expires worthless for the options buyer, then the seller gets to keep the premium as their profit.
Why It Matters To Traders
Premium is the market price of an options contract, and therefore, determines the trader's profits. Overpaying for a buy or accepting too little premium when selling can decrease profits.
(This article originally appeared on ProfitableTrading.com.)