CandleFocus Glossary Editor
Option Premium is the cost of an option which can be either a call (right to buy) or a put (right to sell) that is purchased in the marketplace. It is an agreement between two parties giving the option holder the right but not the obligation to buy or sell a security at a specified exercise price within a certain contract period. The Premium is an important factor in option trading since it can modify the trade-off between risk and reward.
To explain it more clearly, let’s focus on the two driving forces behind an option price: extrinsic and intrinsic value. Extrinsic value is the price of an option above the intrinsic value and comprises the time value and volatility price. The time value increases with time remaining until expiration and higher volatility rising with expectation of possible large movements in the underlying asset. Intrinsic value is measured by the difference between the underlying asset’s current price and the option’s exercise price. Intrinsic value is always zero or greater and increases with the intrinsic value moving further-in-the-money.
The option Premium is the sum of these two basic components, the extrinsic and the intrinsic, with the total value varying depending on how both of these tend to move. A higher intrinsic value will reduce the extrinsic value, from which it is derived. If the intrinsic value rises, it becomes more expensive to purchase the option, as the premium increases. Conversely lower extrinsic value will decrease the total premium.
It is important to understand the behavior of the premium because it affects the decision to buy or sell an option. The option premium is composed of time decay, volatility and the intrinsic value of the option. As the time to expiration decreases, the time value of the option declines, as does the premium. Likewise, if the market sentiment is bearish and the volatility decreases, the premium will decrease as well.
When trading options, it is important to understand the variables that affect the option premium and use these factors to maximize rewards while minimizing associated risks. By using option strategies, investors can price options correctly allowing them to take advantage of premium changes in the marketplace. As a result, the investor can make more accurate decisions on when to enter and exit trades, thus improving the overall rate of return.
To explain it more clearly, let’s focus on the two driving forces behind an option price: extrinsic and intrinsic value. Extrinsic value is the price of an option above the intrinsic value and comprises the time value and volatility price. The time value increases with time remaining until expiration and higher volatility rising with expectation of possible large movements in the underlying asset. Intrinsic value is measured by the difference between the underlying asset’s current price and the option’s exercise price. Intrinsic value is always zero or greater and increases with the intrinsic value moving further-in-the-money.
The option Premium is the sum of these two basic components, the extrinsic and the intrinsic, with the total value varying depending on how both of these tend to move. A higher intrinsic value will reduce the extrinsic value, from which it is derived. If the intrinsic value rises, it becomes more expensive to purchase the option, as the premium increases. Conversely lower extrinsic value will decrease the total premium.
It is important to understand the behavior of the premium because it affects the decision to buy or sell an option. The option premium is composed of time decay, volatility and the intrinsic value of the option. As the time to expiration decreases, the time value of the option declines, as does the premium. Likewise, if the market sentiment is bearish and the volatility decreases, the premium will decrease as well.
When trading options, it is important to understand the variables that affect the option premium and use these factors to maximize rewards while minimizing associated risks. By using option strategies, investors can price options correctly allowing them to take advantage of premium changes in the marketplace. As a result, the investor can make more accurate decisions on when to enter and exit trades, thus improving the overall rate of return.