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

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.

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."

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.

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.

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.

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.