What is Option Premium
Option Premium: Important factor for option premium calculation: The option premium of any contract in option trading is an upfront payment that traders make with the expectation that the price movement will occur as anticipated. If the price moves in their favor, the premium of that particular contract rises accordingly. However, if the price moves against them, the premium declines. Additionally, if the expected movement does not happen within the specified time frame, the premium of that contract also decreases.
The contract you choose, the extent of stock price movement, and the remaining time until expiry are crucial factors that determine the premium of a particular contract.
Before proceeding further, it is important to note that there are numerous contracts and strike prices available in the option chain of a particular stock. Each option contract has a different price, and contracts for different months also have varying premiums. When you trade contracts with a nearer expiry, their option premium is lower. Conversely, contracts with a farther expiry tend to have a higher option premium.
Understanding Option Premium and Its Movement
There are several factors that contribute to the option premium:
Chek: Understanding the Basics of option and difference with equity
Factors Impacting Premium in Option Trading
1. Intrinsic Value
Intrinsic value refers to the inherent value a contract holds after the market closes on the day of expiry. To simplify, consider the following example:
If the Bajaj Finance contract with a 9000-strike price has a premium of 51.85 and the price of Bajaj Finance reaches 9200 on the expiry date:
9200 – 9000 = 200 (Intrinsic Value = 200)
If the expiry price is 9325:
9325 – 9000 = 325 (Intrinsic Value = 325)
If the expiry price is 8900:
The intrinsic value is zero, as the stock price did not reach the contract’s strike price.
Intrinsic value cannot be negative. However, if the expected price movement does not occur, the premium paid for the contract becomes zero, resulting in the maximum possible loss.
2. Time Value
Time value, also known as the remaining time until expiry, represents the probability of the stock price reaching the expected level. This probability contributes to an additional premium.
When analyzing stocks, movement does not always happen immediately. If there is sufficient time before expiry, the chances of benefiting from price movement increase.
If a contract is far from expiry, its premium is generally higher. Contracts for the following month or later have additional premiums due to the increased time value. This explains why options with longer expirations tend to be more expensive.
In the case of in-the-money options, the premium consists of both intrinsic value and time value. However, for out-of-the-money options, the premium is entirely based on time value, as the contract has not yet reached profitability. This makes options an attractive trading tool, as traders can easily establish positions based solely on time value.
If the stock does not move as expected and expiry approaches, the option premium declines. Sometimes, even if the stock price moves upward, the premium may not increase significantly due to the approaching expiry. This is why near-expiry trading is popular, as option premiums become cheaper during this period.
3. Volatility Value
Option premiums are influenced by both intrinsic value and time value, but volatility also plays a significant role.
At times, stock prices move, but the premium does not react as expected. In other instances, rapid price movement occurs, yet the premium does not increase proportionally. This is due to volatility, which adds an extra layer of premium.
Events such as repo rate announcements, GDP data releases, inflation reports, and global economic events contribute to increased volatility. Quarterly and yearly earnings reports also impact option premiums. During these events, option premiums tend to be higher. However, once the event has passed and results are disclosed, the premium usually declines faster than on regular trading days.
FAQ
Q.1 What is an Option Premium?
The option premium is the upfront price paid by traders to buy an options contract. It fluctuates based on factors like stock price movement, time until expiry, and market volatility.
Q.2 Why does the option premium decrease as expiry approaches?
As expiry nears, the time value of the option declines, reducing the overall premium. If the expected price movement does not happen in time, the premium can drop significantly.
Q.3 How does volatility impact option premiums?
Higher volatility increases option premiums because of the potential for larger price swings. Events like earnings reports, economic data releases, and global news can cause temporary spikes in premiums.
Q.4 What is the difference between intrinsic value and time value in an option premium?
Intrinsic value is the amount by which the option is in-the-money (i.e., how much the stock price exceeds the strike price).
Time value represents the potential for the option to become profitable before expiry. It declines over time, eventually reaching zero at expiry.