Understanding option premiums

Investors like options because they improve many market strategies. Do you think the stock will rise? If you are right, buying a call option will give you the right to buy shares at a price below the market value in the future. If the stock actually rises, it means substantial profits. If your stock plummets unexpectedly, do you want to reduce your risk? With put options, you can sell stocks at a preset price later and limit losses.

Options can open the door to huge profits and can also provide protection for possible losses. Moreover, unlike buying or shorting stocks, you can obtain important positions with a moderate amount of upfront capital. Whether you are buying or selling these contracts, understanding the factors of option prices or premiums is critical to long-term success. The more you know about premiums, the easier it is to recognize a good deal.

Key points

  • The option premium is the total amount the investor pays for the option.
  • The intrinsic value of an option is the amount an investor would get if he immediately exercised the option.
  • The time value of an option is that investors are willing to pay anything higher than the intrinsic value, hoping that the investment will eventually be rewarded.
  • Assets that have recently volatile prices have higher option premiums.

Intrinsic Value

There are two basic components of option premium. The first factor is intrinsic value. The intrinsic value of an option is the amount an investor would get if he immediately exercised the option. When the difference is positive, it is equal to the strike price or the difference between the strike price and the current market value of the asset.

For example, suppose that an investor purchases a call option for XYZ company at a strike price of $45. If the current value of the stock is 50 USD, the intrinsic value of the option is 5 USD (50 USD-45 USD = 5 USD). In this case, you can immediately exercise the call option to get 500 USD (5 USD x 100 shares). This choice is called money.

However, if you buy an XYZ call option with a strike price of $45 and the current market value is only $40, there is no intrinsic value. This is the well-known lack of money. The second part of the option premium comes into play now, detailing the length of the contract.

Time value

Your option contract may lose money, but it will eventually become valuable due to major changes in the market price of the underlying asset. This is the time value of the option contract. Roughly translated, it means that investors are willing to pay any price higher than intrinsic value, hoping that the investment will eventually be rewarded.

For example, suppose someone buys an XYZ call option at a strike price of $45, and the underlying asset drops from $50 to $40. This option is now worthless. However, the stock may rebound within a few months and reinvest the options.

Option prices include the bet that the stock will pay off over time. Suppose a speculator buys a call option with a strike price of $45. Since the stock sells for $50, its intrinsic value is $5. Investors may be willing to pay an additional $2.50 to hold a one-year contract because they expect the stock to rise. This will make the total premium of $7.50 ($5 intrinsic value + $2.50 time value = $7.50 premium).

Naturally, all other conditions being equal, options that expire later have a higher time value. The time value of an option that expires in one year may be US$2.50, while the time value of a similar option that expires in one month is only US$0.20.

Change in option value

Option premiums are constantly changing. This depends on the price of the underlying asset and the time remaining in the contract. The deeper the contract is in the currency, the more the premium rises. Conversely, if the option loses its intrinsic value or deviates further from the currency, the premium decreases.

The time remaining in the contract will also affect the premium. For example, as the contract approaches expiration, the premium will decrease. However, the rate of decline may vary greatly. This time decay is an important factor in the calculation of time values.

Many options expire worthless, so considering time decay is essential to avoid and limit losses.

You may not pay large sums for call options on blue chip stocks, and you will not put them within a 30-day window before expiration. It works like this because the chance of large-scale price changes in a short period of time is very low. Therefore, its time value will gradually decrease before expiration.

Measure volatility

Generally speaking, the option premium for assets that have recently fluctuated significantly in price is higher. Option premiums for volatile securities, such as popular growth stocks, tend to decay more slowly. With these tools, the odds of an out-of-the-money option reaching the strike price are much higher. Therefore, the time value of the option is maintained longer.

Because of these changes, option traders should measure the volatility of stocks before placing bets. A common way to accomplish this task is to look at the standard deviation of the stock. According to historical data, the standard deviation measures the degree of fluctuation relative to the average price. A lower number indicates a relatively stable stock, which usually requires a lower option premium.

Bottom line

Options support various strategies of experienced investors, but they do have risks. Understanding pricing factors, including volatility, can increase the likelihood of options for higher returns. However, investors should study option Greeks to better understand option premiums.

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