6 Things To Know About Option Premiums
I f you’re considering getting into options trading, you need to understand option premiums. This is the price you pay for the options contract, and the cost of the premium can determine whether you want to move forward with a trade. Understanding option premiums and the different variables that affect the premium can help you determine whether a trade is a good move or not.
- The option premium is the price the trader pays when buying a call or put option.
- There are many factors that can affect the premium price, including the intrinsic value of the option, amount of time until the option expires, and market volatility.
- Premiums are always changing based upon market prices and time decay, and it’s important to always evaluate the volatility of the market based on historical data to understand whether a premium will remain high or go down.
What Is an Option Premium?
Image via Unsplash by chrisliverani
An option premium is a fee that a trader pays to buy a contract for a call or put option. When you pay for these contracts, you have the right to buy or sell the underlying stock at the specific price within a specified time frame. The amount that a trader pays for the option is dependent upon three main factors: the price of the stock on the open market, the level of risk, and the length of time before the contract expires.
Understanding Stock Options
B efore we take a deeper look at option premiums, it’s important to have a basic understanding of how options trading works, if you don’t already. A stock option, as mentioned, is a contract that gives a trader the right, although not the obligation, to buy shares of stock at a specific price, the strike price, by a specific date. There are two different types of stock options: call and put options. If a trader thought that the market prices for a particular stock were going to go up in the future, the might buy a call option to lock in a strike price at a lower rate and if the prices went up, could buy the shares and sell them for an immediate profit.
A put option gives the trader the right to sell the shares at the strike price. A trader might buy put options if they expect the price on the market to drop. This would allow them to sell shares of the stock option at the strike price for a profit, as long as they exercised their option before the expiration date. The act of buying or selling the option is referred to as exercising the option.
How Options Premiums Are Calculated
Options premiums are calculated by adding the time value and the option’s intrinsic value.
The intrinsic value for the option is the difference between the current price of the stock on the market and the strike price for that contract. To find the intrinsic value for call options, you would subtract the strike price from the price of the stock shares. For a put option, you do the opposite and subtract the price of the underlying shares from the strike price.
Let’s say that you’re thinking about buying an option for a stock with a strike price of $45, and it’s currently trading for $41. If you were to exercise that option, you would make $6 per share. That makes the intrinsic value for that option $6. However, if the stock dropped below $45, then the intrinsic value is $0. When an option has no intrinsic value, it is known as being out of the money, or OTM.
The length of time until an options contract expires also affects the cost of the premium payment. The more time there is before the option reaches the expiration date, the more time that the market has to move past the strike price and allow the trader to earn a profit on the options contract.
It only makes sense that if you’re choosing between two different options with the same strike price and different expiration dates, you would likely pay a higher premium for the option with the expiration date that’s further out. Doing this gives the market more time to make moves and more time for you to exercise your option and earn a profit. When the time value for the stock option is going down, it’s known as time decay. As time decay occurs, it ultimately means that the value of the option is going to drop.
Implied volatility is another consideration for time value. If the market is highly volatile, then there’s a stronger likelihood that the price for the stock option will move past the strike price, even if the amount of time until the stock option expires isn’t long. Therefore, you can often expect that when you buy a stock option in a volatile market, you likely will pay a higher premium.
You can determine the time value for the option by subtracting the option’s intrinsic value from the premium. For example, if the price of the stock on the market is $50 and you purchase a call option that has a strike price of $45, and the option premium is $200, then the intrinsic value is $5 ($50 – $45) and the time value is $195 ($200 – $5).
In general, you can expect the premium price to be higher for stocks that have had higher levels of pricing volatility recently. The option premiums for volatile stocks generally decay more slowly. Because the pricing is volatile, even if a stock is out of the money, the chances of it reaching the strike price are much higher. It makes sense, then, that it would hold its time value for longer.
For this reason, it’s usually a good idea to look at the volatility of the stock you’re considering buying an option for before you move forward with paying the premium. One way you can do this is by looking at the standard deviation for the stock. The standard deviation is a measurement of the degree of a stock’s movement up and down in comparison to the mean average.
A lower standard deviation means that the stock prices are relatively stable. In this case, you can generally expect a lower premium payment.
While you may not be familiar with gamma, delta, theta, rho, and vega, these are just measures of the individual risks that are associated with options trading. The Greeks help you calculate risk for each of the different variables that impact the price of the option, which can ultimately help you decide whether you want to buy an option or whether the premium price is too high.
- Delta: Delta is a ratio that compares the change in the price of the stock on the market to the change in the price of the stock option. It allows you to evaluate how sensitive the price of the option is in comparison to the movement of the underlying security.
- Gamma: Gamma measures how the delta rate changes over time. It allows you to see how much an option’s delta ratio moves for every movement in the market for the stock.
- Theta: This refers to the rate of decline in an option’s value. The problem with this metric is that it assumes market volatility and price movement are constant.
- Rho: This is a measurement of an option’s sensitivity to interest rate changes.
The Changing Value of Stock Options
T he premium for a stock option is continually changing depending on the price of the stock on the open market, the time left until the option expires, and even whether the market is particularly volatile. The deeper that a contract is in the money, the higher the cost will be for that premium. Likewise, the further a contract is out of the money and the less intrinsic value it holds, the lower you can expect the premium to be for that contract.
As the expiration date for a contract approaches, the premium will start to decline. The rate at which the premium will decline can vary significantly from one option contract to the next, and market volatility can impact how quickly it declines.
Options are a great way for traders to protect against the downside risk, or even earn money on stocks they own when the market is stagnant. By understanding the different factors that affect the pricing of premiums, including market volatility, investors can increase the likelihood of achieving higher returns. By learning and understanding the option Greeks, traders can gain a deeper, more thorough understanding of option premiums.