Understanding the Premium

Hey guys, welcome back to our option trading course.

In this chapter, let's look at what impacts an option's price, i.e., its premium.

The premium of an option is made up of two parts: intrinsic value and time value.

By comparing the stock price against the strike price, we'll see whether an option has any intrinsic value. While time value is affected by the amount of time remaining until the expiration of the option contract.

Let's look at a hypothetical example of Rabbit Inc., which is currently trading at $38 per share. Suppose a trader owns a call option at a $36 strike expiring 30 days later. The premium is $4 per share.

As Rabbit’s stock price is $2 per share higher than the strike price, its call is considered in-the-money. In this case, the intrinsic value is the amount by which an option is in-the-money, which is $2 per share.

Let's say the Rabbit stock rises to $40 per share, the intrinsic value of the call will also increase.

If the Rabbit stock falls to $35 per share, the call is considered out-of-the-money. Then the option has no intrinsic value, only time value.

For a put, the opposite is true. A put option is ITM when the stock price is below the strike price. The intrinsic value is the amount by which a put option is in-the-money. If the stock price falls, the intrinsic value of the put will increase. If the stock price rises above the strike price, the put is considered out-of-the-money. Then it has no intrinsic value, only time value.

Time value is affected by time. Time refers to the number of calendar days until expiration. Generally, the more time an option has, the higher its time value.

For example, there are two Rabbit calls at a $36 strike price. The option of 30-day expiration is more expensive than the 7-day one because the former has more time value.

It's worth noting that as time passes, the time value of an option decreases. This is called "time decay".Moreover, the decay is not linear; the closer the option is to expiration, the faster the decay will be.

Implied volatility also goes into affecting an option's premium. It refers to how much the market expects the underlying stock to rise or fall.

Suppose Rabbit option's implied volatility is 30%, It means that the share price of Rabbit, Inc. is expected to move up or down by 30% next year.

The higher the implied volatility, the more expensive the option.

To summarize, we can break down an option's premium into two categories: the intrinsic value and the time value.

Underlying price, time, and implied volatility are three important factors affecting an option's premium.

In the next chapter, we'll talk about how to pick options.