Option premium is the price of an option: the amount the buyer pays the seller for the rights the contract gives. It is paid in full when the trade is made and is not refunded, whether or not the option is ever exercised. For the buyer it is the most that can be lost. For the seller, also called the writer, it is the most that can be gained and the compensation for taking on the obligation.
The premium is set by trading in the options market, like any other price. It can be divided into two parts, intrinsic value and time value, and it moves continuously as the price of the underlying, the time remaining and the market's view of future volatility change.
Quotation and contract value
Premiums are quoted per unit of the underlying. The cash amount that changes hands is the quote times the contract multiplier:
A standard US equity option covers 100 shares. A call quoted at 2.50 therefore costs dollars per contract, plus commission. Options have a bid and an ask like shares, and the bid-ask spread is often wide relative to the premium, particularly for contracts far from the money or with distant expiries. The midpoint, or mid price, is used as a reference for fair value.
Intrinsic value and time value
The premium is the sum of two components:
- is what the option would be worth if exercised now: the amount by which it is in the money, or zero.
- is the remainder, the amount buyers pay for the chance that the option becomes more valuable before expiry.
With a share at 108, a call struck at 100 and priced at 11.50 has intrinsic value of 8 and time value of 3.50. A call struck at 115 and priced at 1.20 has no intrinsic value, and its whole premium is time value. Time value is greatest for options at the money and declines to zero at expiry.
- Price of the underlying relative to the strike. A call is worth more as the underlying rises above the strike price, and a put is worth more as it falls below.
- Time to expiry. More time means more opportunity for a favourable move, so longer-dated options cost more. The daily erosion of premium is measured by theta.
- Volatility. The more the underlying is expected to move, the more both calls and puts are worth. The volatility figure consistent with a given premium is the implied volatility, and sensitivity to it is measured by vega.
- Interest rates. Higher rates raise call premiums slightly and lower put premiums.
- Dividends. Expected dividends lower call premiums and raise put premiums, since the share price falls when a dividend is paid.
Pricing models such as the Black-Scholes-Merton model combine these inputs into a theoretical premium. In practice traders run the model in reverse: they take the market premium as given and solve for implied volatility, which is then compared across strikes and expiries.
The writer receives the premium at the outset and keeps it whatever happens. If the option expires out of the money, the premium is the writer's profit. If it is exercised, the premium offsets part of the loss. Strategies such as the covered call are built around collecting premium as income.
Because a writer's potential loss can far exceed the premium received, exchanges require writers to deposit margin. The clearing house for the market collects it and guarantees performance to the buyer, so the buyer does not depend on the creditworthiness of the particular seller. A buyer, by contrast, pays the premium in full and has no further obligation.
On average, option premiums have been somewhat higher than the subsequent movement of the underlying would have justified, especially for index options. This excess is called the volatility risk premium. It is the reward sellers earn for bearing the risk of sudden large moves, and it is not a free gain: the losses, when they come, are large and arrive together.
Other meanings and conventions
Premium has unrelated uses elsewhere in finance, including the price of an insurance policy, the amount by which a bond or fund trades above its face or net asset value, and a risk premium in asset pricing. In options the word always means the price of the contract. On some futures exchanges, options on futures are margined like futures, with the premium settled through daily gains and losses instead of being paid at the start. In over-the-counter markets the premium may be quoted as a percentage of the notional amount or in volatility terms. The pay-out the premium buys is described under option payoff.