Options: Premium

OPTIONS: PREMIUM

In one sentence – Option premium is the price of an option contract.

Pay premium to whom?

The premium is paid upfront by the buyer of the option to the seller. Option premium is not a fixed amount. It keeps changing according to the Moneyness status of an option. For an in-the-money option, the premium quoted will be more than an out-of-the-money option. As the option keeps moving in the money, the premiums will also increase..

Premium is different from brokerage.

The premium paid by the buyer to the seller should not be confused with the brokerage costs normally incurred to trade in options market.

Brokerages are paid separately based on the agreement between you and the broker – it could be based on volume or number of transactions or a flat charge per transaction or whatever. All the participants have to pay brokerage.

Premium is different. The writer of the option receives premium from the buyer.

Only the buyer pays premium. Not the seller!

In our first post on options, we said that the buyer purchases the ‘right’ to buy or sell an option. He enjoys the luxury of opting to buy or sell if situations are favorable to him or else he will let his option lapse. The seller on the other hand, is always obligated to perform. He doesn’t have a choice. Hence, the seller’s stand is always risky and for bearing that risk, he is compensated by the buyer by paying upfront -that’s what we call as ‘premium’. Hence, premium is never paid by seller to the buyer. It always paid by the buyer to the seller. It’s a source of income for the seller.

So premium, in short, reflects what the buyers are willing to pay and what sellers are willing to accept for the option.

TWO COMPONENTS OF OPTION PREMIUM

The option premium is a combination of two elements.

Intrinsic value: Only in the money option will have intrinsic value. Intrinsic value is the difference between the strike price and the current market price of the underlying stock.

Extrinsic value: Extrinsic value is the value of the option over an above the intrinsic value.

For example – Let’s assume that the stock of RIL is trading at Rs 750 and RIL call option at strike 700 is available at a premium of Rs 70. In this case, the intrinsic value of the option will be Rs 50 (Strike price minus current market price) and the remaining Rs 20 will be the extrinsic value.

This extrinsic value of Rs 20 is also called the ‘time value’.

TIME VALUE? ….How? …Why?

The first part of an option premium is clear. There will not be any confusion about how an option gains intrinsic value since it is quite straight – when the market price of the underlying stock is greater than the option strike price, the difference results in  intrinsic value.

The second portion, time value, needs a closer look. An option gains time value from the probability that it can move in the money further and become more profitable by the time the option expires. Longer the time to expiry, higher the probability for profits. Shorter the time to expiry, lesser the chance.

Hey! That’s just one side of the coin!

You’re Right. The reverse can also happen- there is an equal probability that an in the money option may decrease further and become less profitable by the time the option expires.

So time remaining till option expiry and the degree of volatility of the underlying stock decides how much further the option would go in/out of the money. Now, we hope you’ve got the picture clear. Apart from the intrinsic value, the probability of further profits/losses are also weighed in by the participants and that’s how an option gets time value automatically added to it.

It is also clear from the above explanation that time value of an option is a function of two factors:

  • The underlying stock’s chances of moving up or down in price. In simple words- the stock’s volatility , and
  • The time remaining for all this to happen. Longer the time; greater the chances.

So,  there are two ways to explain what time value /extrinsic value is – from the call buyer’s point of view, it  is the price over and above the intrinsic value that he is willing to pay for participating the in the potential upside. From the writer’s point of view, it is his ‘charge’ for undertaking higher potential risk.

Before we end, here are some more tips –

  • Option premium is paid upfront.
  • Premium is paid by the holder to the writer
  • You have to pay option premium regardless of whether or not the option is actually exercised.
  • Premiums have nothing to do with brokerage.
  • The time value decreases as the expiration date approaches.
  • Time value would be ‘0’ on expiry.
  • Out-of-the-money options has zero intrinsic value and hence, time value = option price.
  • Higher volatility of the underlying stock leads to higher time value.
  • Time value also depends on how close-to-the-money an option is. So, two call options having the same time left to expiry but with different strike prices will have different time value. This is because one will be closer to the money than the other.
  • Since dividends affect the market price of underlying stocks when declared, it also plays a part in deciding option premiums.
  • Needless to say, risk free interest rates are always considered for any financial decision and options are no different.

To sum it up- The price /value / premium of an option is determined by price of the underlying, its volatility, strike prices of the option, expected dividends, risk free interest rates and time remaining till expiry.

That’s option premium for you.

Unfortunately, options traded in India are not called ‘Indian options’. Irrespective of the geographical location, options traded anywhere in the world are either called ‘American options’ or ‘European options’!! More about that in our next post.

You may like these posts:

  1. Options: Understanding strike price.
  2. Options: Kick off
  3. Options: Moneyness.

1 Response to “Options: Premium”

Ritesh

June 20, 2012 at 10:59 pm

hey, i have a query. who writes an option and what is the role of the stock exchange in this process??

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