The option premium is the amount per share that the option buyer has to pay the options seller. There are many things that affect the amount the buyer has to pay, but the three most important are the amount of time the option has left before expiry (the time value) the intrinsic value and the volatility of the underlying asset.
There are other factors that affect the option premium such as interest rates, market conditions and dividend rates. But the affect of these on the options premium is minimal during normal trading conditions.
So we’ll focus on the three most important factors. Keep reading and we’ll cover each one of them in more detail and show you why they’re so important.
Which Three Factors make up the Option Premium?
Intrinsic Value – Simply put the intrinsic value of an option is how much in the money the option is currently trading.
For example, let’s say Coca-Cola (KO) is trading at $69.68. The KO call option with a strike price of 60 (KO 60 call option) would have an intrinsic value of $9.68 ($69.68 – $60 = $9.68) because the option holder can exercise his option to buy KO shares at $60 and then turn around and automatically sell them back to the market for $69.68 making a profit of $9.68.
It’s important to note that intrinsic value works in reverse for put options. For example, a KO 60 put option would have an intrinsic value of zero ($60 – $69.68 = -$9.68) because the intrinsic value cannot be a negative value it’s rounded up to zero. On the other hand, a KO 70 put option would have an intrinsic value of $0.32 ($70 – $69.68 = $0.32).
Call Option Intrinsic Value = (Market Price – Call Strike Price)
Put Option Intrinsic Value = (Put Strike Price – Market Price)
Time Value – The time value is the difference between the price paid and the intrinsic value and decays over time until expiry when it reaches zero.
For example, if KO is trading at $69.68 and the one-month to expiration KO 60 call option is trading at $10.00, the time value of the option is $0.32 ($10.00 – $9.68 = $0.32).
Time Value = (Options Price – Intrinsic Value)
To emphasize the point that the time value is directly related to the length of time left before expiry, let’s look at another example. This time we’ll look at an option with a longer time frame of 9 months.
With Coca Cola (KO) trading at $69.68 and a KO 60 call option trading at $12.68 with nine months to expiry, this time we have a time value of $3.00. ($12.68 – $9.68 = $3.00). Notice that the intrinsic value remains the same the only difference is the time value which has increased due to the length of time before expiry.
Volatility – The option premium is also highly dependent on the volatility of the underlying market. Volatility is a measure of the rate and magnitude of the change of direction (up or down) of the underlying market. If volatility is high, the premium on the option will be relatively high, and vice versa.
Once you have a measure of volatility for any underlying asset, you can plug the value into the standard options pricing model and calculate the fair market value of an option.
This may seem complicated at first but you’ll see all these values reflected for each available option when you log into your trading account; it’s as well to know what they all mean.
Once you’ve carried out a few trades you’ll have a better understanding of how all these elements work together to create the options premium and how these figures are worked out.
optionsXpress have an excellent training tutorial on trading options, which every rookie should check out. There you’ll find a bunch of trading examples which look at the option premium and the way volatility affects market prices in more detail.