What is Options Premium & How Does it Work?

Options premium is another way to refer to the value of an options trade. For the buyer, the premium represents the cost to obtain the right—without the obligation—to buy (call option) or sell (put option) the underlying asset at a specified strike price before the option’s expiration. For the seller, the premium represents the amount they receive upfront as compensation for potentially fulfilling the contract terms if the option is exercised. Regardless of which side of the trade one is on, the premium remains the same.

For both buyers and sellers, the premium carries significant implications. Buyers seek to minimize premium costs to lower their initial investment, while sellers aim to collect higher premiums to enhance their profit potential. The premium fluctuates as market conditions change, particularly with shifts in the underlying asset’s price and volatility. Understanding the dynamics of premium is crucial for all investors and traders active in the options markets, because it directly affects the risk and profitability potential of a given trade in this universe. 

Options premium represents the cost involved in trading an options contract, whether you're the buyer or the seller. This premium is determined by a combination of potential intrinsic value and extrinsic value. Intrinsic value reflects the difference between an in-the-money (ITM) option's strike price and the current market price of the underlying asset, providing immediate value if the option were exercised right away. Extrinsic value, or time value, encompasses additional factors like the time left until expiration, implied volatility, and prevailing interest rates. Together, these values influence the premium and fluctuate as market conditions change.

For buyers, the premium is an upfront cost that grants the right to buy or sell the underlying asset, depending on whether it’s a call or put option. Buyers are willing to pay the premium because it offers potential profit through favorable price movements in the underlying asset. For sellers, the premium is the income received for assuming the obligation to fulfill the option’s terms if it’s exercised. Sellers aim to collect higher premiums to increase profit potential, but they also bear the risk associated with the obligations of the contract.

Key factors influencing the premium include the price movement of the underlying asset, shifts in implied volatility, and the passage of time. As expiration approaches, the extrinsic value decreases, often causing the premium to drop—a process known as time decay. That means, all else being equal, an option’s premium will gradually decline as it nears expiration, especially if it lacks intrinsic value. All extrinsic value decays to $0.00 by the expiration of the options contract. Any remaining value is intrinsic value if the option is ITM.Understanding these dynamics is crucial for traders, as they directly impact the risk and profitability potential of a given options position.

The premium of an option is influenced by several key factors that determine its value throughout the life of the contract. These include intrinsic value, time to expiration, implied volatility, interest rates, and the price of the underlying asset. At any given point in time, some (or all of these factors) may catalyze a shift in the premium associated with a given option. In some cases, that shift could be dramatic in nature.

• Intrinsic Value: This is the immediate value of an option if exercised. For call options, intrinsic value exists when the underlying asset's price is above the strike price; for put options, it’s when the underlying asset’s price is below the strike price. Options with intrinsic value are “in-the-money” (ITM) and carry a higher total premium than out-of-the-money (OTM) options that are purely made up of extrinsic value.

• Time to Expiration (Time Value): The amount of time until the option’s expiration date impacts the premium due to time decay. Longer expiration times typically result in higher premiums, as there is more time for the underlying asset to move. As expiration nears, the time value decreases, reducing the overall premium.

• Implied Volatility: Implied volatility reflects the market's expectations for future price movements. Higher volatility increases the likelihood of the option moving in-the-money, which raises the premium. Conversely, low implied volatility suggests smaller potential price movements and results in a lower premium.

• Interest Rates: Changes in interest rates can also affect option premiums, though the impact is generally smaller. Higher interest rates can increase call option premiums, while reducing put option premiums, because interest rates influence the cost of holding the underlying asset.

• Price of the Underlying Asset (Moneyness): The underlying asset’s price directly affects the premium, as it determines the intrinsic value of the option, particularly when it is near the strike price. This relationship is often referred to as "moneyness," which indicates the option's value in relation to its strike price and the underlying asset's price. For example, an “in the money” call option has a strike price below the market price, increasing the premium, while an “out of the money” option has no intrinsic value and a lower premium. Real-time price movements lead to constant adjustments in the premium as market conditions change.

Calculating the option premium involves adding the intrinsic value and extrinsic value of the option. The intrinsic value reflects the value of the option if it is exercised immediately. The extrinsic value, or time value, accounts for additional factors like time until expiration, implied volatility, and interest rates. The formula for calculating premium is therefore fairly straightforward: Option Premium = Intrinsic Value + Extrinsic Value.

Now let’s examine a couple of examples to illustrate the calculation of an option’s premium, and remember, option prices are presented on a 100 share basis, so a $1.00 option quote is really $100 dollars: 

Example 1: In-the-Money (ITM) Call Option

• Suppose a call option has a strike price of $50, and the underlying asset is currently trading at $55. The intrinsic value is the difference between the asset price and the strike price: $55 - $50 = $5. If the extrinsic value (based on time, volatility, etc.) is $2, then the total premium is: Option Premium = $5 (Intrinsic Value) + $2 (Extrinsic Value) = $7.00 ($700 dollars).

Example 2: Out-of-the-Money (OTM) Put Option

• Imagine a put option with a strike price of $40, but the underlying asset is trading at $45. Since the option is out of the money, the intrinsic value is $0. If the extrinsic value is $3, then the total premium is simply the extrinsic value: Option Premium = $0 (Intrinsic Value) + $3 (Extrinsic Value) = $3.00 ($300 dollars)

The option premium is dynamic and fluctuates continually based on market conditions, particularly as it approaches expiration. Several key factors contribute to these changes, including time decay, price movements in the underlying asset, and shifts in implied volatility. As time progresses, the premium's extrinsic value decreases, a process known as time decay, which accelerates as the option nears expiration. This means that, all else being equal, the premium tends to decline over time as the chance for the option to move into a profitable position diminishes.

Additionally, the underlying asset’s price and implied volatility can cause the premium to rise or fall. For example, if the asset’s price moves favorably in relation to the strike price, the option may gain intrinsic value, increasing the premium. Conversely, if implied volatility rises, it can lead to a higher premium due to the greater likelihood of significant price swings before expiration. On the other hand, as expiration approaches and time decay intensifies, even options that are in the money may see a drop in their premium.

At expiration, any remaining extrinsic value disappears, leaving only the potential intrinsic value. Once expired, the premium no longer changes, as the option either becomes either worthless or is exercised. Understanding these factors helps traders anticipate how an option’s premium will evolve over its lifespan, impacting their trading approach and risk management strategy. 

Options premium is directly impacted by implied volatility, which reflects the market's expectations for future price movements. When a “volatility crush” occurs—typically following a major event like an earnings announcement or significant news release—implied volatility often declines sharply. This abrupt decrease in volatility can lead to a sharp reduction in the extrinsic value of options, which can then reduce the overall premium of the impacted options. 

A volatility crush can significantly affect options prices, particularly if a trader has purchased options at elevated premiums due to high implied volatility leading up to the event. After the event, if implied volatility falls substantially, the premium can decline even if the underlying asset’s price hasn’t changed, as the option’s extrinsic value erodes. This is especially impactful for out-of-the-money (OTM) options, which are purely made up of extrinsic value, making them susceptible to sudden losses in premium due to a volatility crush.

In some cases, short options positions may benefit from a reduction in premium during a volatility crush. However, it’s important to note that short options carry significant risks if the underlying asset experiences a large, unfavorable move. In such instances, the potential losses from the underlying asset’s movement can sometimes exceed the benefits gained from the volatility crush. For this reason, it’s crucial for options traders to have a solid understanding of the mechanics of options premium, and the associated risks. 

The prices observed in the options marketplace represent what traders are willing to pay or receive for an option at any given time. When executing a given options trade, the amount that the option buyer outlays, and the amount that the seller receives, are often referred to as premium. A key distinction is that the "value" of an option usually refers to its theoretical value, typically calculated using a model like Black-Scholes, whereas the "premium" is the actual price paid/received in the marketplace. 

When options expire, the outcome for the premium depends on whether the option is in-the-money or out-of-the-money. If the option expires out-of-the-money, it holds no intrinsic or extrinsic value, as the premium falls to zero and the option becomes worthless. Conversely, if the option expires in-the-money, the premium reflects only the intrinsic value—the difference between the strike price and the underlying asset's price—representing the value from exercising the option. In either case, extrinsic value drops to zero at expiration, as there is no time remaining for future price movements to influence the option's overall value.

Implied volatility (IV) represents the market’s expectations for future price movements and is a key factor in determining an option’s price (or premium). Higher implied volatility indicates a greater likelihood of significant price swings, and that generally increases the extrinsic value of an option’s premium. When implied volatility is high, option premiums tend to be more expensive due to the anticipated market volatility.

On the other hand, implied Volatility Rank (IV Rank) is a metric that helps traders assess the current level of implied volatility relative to its historical range. IV Rank compares the current IV to its highest and lowest levels over a specified period, usually the past year, and expresses this as a percentage. For example, an IV Rank of 80% indicates that the current implied volatility is higher than 80% of levels observed during that period, suggesting a relatively high, and potentially expensive premium.

By using IV Rank, traders can better assess whether an option’s price (aka premium) is cheap, fair, or expensive. A high IV Rank generally implies that the premium is expensive due to its position at the upper end of the historical range. This situation can be favorable for selling options, with the intent of capturing higher premiums. 

Conversely, a low IV Rank is generally indicative of lower implied volatility, suggesting that prices (aka premiums) are on the lower end of the 52-week range. Similarly mid-range IV Ranks often signal that premiums are closer to fair, as implied volatility is trading around the “typical” level observed in that options contract. As such, IV Rank can help participants in the options markets make better-informed decisions by providing key insight into the relative value (aka premium) of an option.