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How to Do an Option Premium Calculation

Purchasing an option on the stock market gives you the right to buy or sell shares of a specific asset at a specific price by a certain date. The price at which you can buy the shares is called the strike price, while the price you pay for the option itself is the premium price.

An option is profitable, or ‘in the money,’ when the asset’s market value exceeds the strike price for a put option and vice versa for a call option. Options that are not in the money, including both at-the-money and out-of-the-money options, are worthless. Review these steps to complete the option premium calculation and learn about why this metric is so important for options traders.

Steps to Calculate an Option Premium:

  • Understand the Option Premium Calculation: Also called an option’s extrinsic value, the premium is the price you pay for a stock or asset option.
  • Find the Option’s Intrinsic Value: Determine the amount by which you could profit from exercising the option by subtracting the strike price from the underlying asset price.
  • Calculate the Option’s Time Value: This metric indicates the amount over the premium a buyer would be willing to pay for the option.
  • Add Intrinsic Value to Time Value: The sum of these two numbers equals an option’s premium. Some options have a higher adjusted premium because of their volatility.
  • Consider the Role of Delta: This metric shows how an option premium changes in relation to the underlying asset price changes.

Understand the Option Premium Calculation

Image via Flickr by 401(K) 2013

Traders who invest in options must understand the value of an option premium, sometimes called the extrinsic value of the option. When you pay a premium for a call option, you can buy the stock at the strike price before the expiration date, while a put option lets you sell a stock at the strike price by the expiration date.

When you buy an option, you must pay the nonrefundable upfront premium. You can’t get the premium back if you decide not to exercise the option.

An option quote represents a per-share premium price. Generally, these options commit you to buy or sell 100 shares of the stock in question if you decide to exercise the option. For example, a 25-cent option premium would actually cost $25 for the option to trade 100 shares.

Option premiums also serve as an income stream for investors who sell put and call options. Any price for an option that appears on an exchange like the Chicago Board Options Exchange is considered a premium cost because it does not have an inherent value.

Factors that affect an option’s premium price include:

  • The perceived volatility of the asset.
  • The remaining life of the option.
  • Whether the option is currently out of the money, in the money, or at the money. The more an option is in the money, the higher its premium price.
  • The price of the underlying asset, which pushes the premium price in the same direction for a call option and in the opposite direction for a put option.

Read on to get the formula for how to calculate an option premium. Looking at an option premium calculation example can help you better understand this fundamental trading concept.

Find the Option’s Intrinsic Value

The current market value of an option is known as its intrinsic value. This measures the amount by which an option is in the money, which means it will produce a profit.

An out-of-the-money option, on the other hand, is worthless, with an intrinsic value of $0. You would not incur a loss because you would simply let the option expire without taking action.

Let’s say you bought a $35 call option on a stock that has a current market value of $50. That means the option is $15 in the money. You would receive an instant profit of $15 per share if you exercise your option since you can buy each share worth $50 for $35.

In this example, $15 is the intrinsic value of the stock. To find the intrinsic value for an in-the-money option, subtract the strike price from the current trading price.

In summary, calculate the intrinsic value of an in-the-money call option by subtracting the strike price from the price of the underlying asset. For an in-the-money put option, subtract the price of the underlying asset from the strike price.

Calculate the Option’s Time Value

If you can find a trader to buy your option at a cost above its intrinsic value, that amount is the option’s time value. The trader is hoping that the option will gain even more value before it expires. For this reason, an option with months until expiration will have a higher time value than an option with weeks or just days left to go. An option within hours of expiration has little to no time value.

Let’s return to the example above, where we calculated an intrinsic value of $15. The stock is currently trading at $50, and we have a $35 call option. If the current premium price of the option is $17, the time value would be $2. Subtract the intrinsic value from the current option premium price to get the time value.

If the option is not in the money, the time value equals the premium price since the intrinsic value is $0.

Add Intrinsic Value to Time Value

The option premium formula is simply the sum of the option’s intrinsic value and its time value. For at-the-money and out-of-the-money options, the time value is always equal to the option premium price.

If you calculate the time value and intrinsic value of an option, you’ll have a better understanding of whether that option is actually worth your money. The intrinsic value represents the value of the option if you exercised it right now, while the time value predicts the possibility that the option will increase in value before time runs out.

These concepts are inherent in realizing an option’s potential risks and profits. For example, an option that is out of the money or at the money is associated with a higher risk of losing all value by the expiration date than with an in-the-money option. On the flip side, at-the-money and out-of-the-money options also carry the chance of becoming in the money before expiration, which would result in larger profit percentage gains than with an option that starts in the money.

Consider the Role of Delta

Delta describes the amount an option premium changes with every one-point change in the underlying security. A call option can have a delta ranging from 0 to 1 and moves in the same direction as the underlying asset. A put option can have a delta between -1 and 0 and moves in the opposite direction of the underlying asset.

Let’s look at an example to illustrate how the delta of an option premium works. You have a call option on a stock that’s currently trading at $50. The premium is $10 and has a delta of 0.5, which can also be expressed as 50%. That means for every $1 the stock moves, the option premium moves by 50 cents in the same direction. In this example, if the price of the underlying stock rises to $52, the premium would rise to $11.

Now let’s pretend you have a $10 put option on the same stock with a 0.75 delta. For every $1 the underlying stock moves, the premium moves 75 cents in the opposite direction. If the stock price drops to $45, the option premium price would rise to $13.75.

The higher the premium price of an option, the higher the potential value that option has. Reviewing the delta of an option can help inform your strategy. As the delta of an option premium approaches 1 for a call option or -1 for a put option, the option becomes further in the money and grows more valuable.

Now that you know how to calculate an option premium, you can harness the value of this knowledge as you become acclimated to the complex yet rewarding world of options trading.