Option premiums are the profit a trader recovers after having sold an options contract. They are also the current market price per share of a contract that hasn’t reached expiration. Option premiums are to be paid to sellers of the options contract.
Basics of Option Premiums
Premiums are essentially the total price to trade options contracts. This means traders have the opportunity to trade at higher volumes without technically owning a large stake in the stock.
With options premiums, you can have less invested into the market and still benefit from market movements. While there is significantly less risk, the returns are often less than trading on the actual market.
What Is an Example of an Option Premium?
There are many variables that contribute to how the premium is to move. When the option premium moves it can be factored by call and put trades.
For example, as the stock value increases the call option will increase while the put option decreases. While the opposite is true for a bearish trade. When the stock value decreases in value, the premium of the put option increases while the call option sets to decline.
For example, you decide to sell an option of ABC stock for $10.00 ($10.00 x 100=$1000). If the option is bought back and closed at $2.00 in turn the premium is turned into profit and $200 is made.
How Are Option Premiums Calculated?
Option premiums can be calculated by adding the option’s intrinsic value to its time value.
This is the value held when exercising at current market value. For example, if ABC company is currently valued at $10 and the investor buys a call option with a strike price of $5. The option has an intrinsic value of $5 ($10 – $5 = $5) which the investor would exercise on. In this example, the call option would benefit the investor and turn a profit of $500 ($5 x 100 shares). While the opposite is true, if the call options strike price value is higher than the current market value, the investor would be at a loss (out-the-money).
Implied Volatility and Option Price
Implied volatility is the expected volatility of a stock’s future price changes which is directly related to stock option price. It affects options price because it represents the stock option price. Stocks that are higher in price for a premium in turn are bound to have a higher implied volatility.
So what does this all mean?
To break it down, implied volatility doesn’t determine the direction of a stocks price, instead stocks typically have higher and lower volatility rates due to anticipated movement in the market.
When buyers are willing to pay more, sellers will increase prices for options contracts. This leads to some contracts having increased implied volatility. When options contracts are not being actively deemed by buyers, sellers are then faced with decreasing prices for their contracts, leading to decreased implied volume.
How to Measure Volatility
Volatility is an important variable in finding accurate options prices. The higher the volatility the more risk the trader takes on. While the lower the volatility the lower amount of risk to be inquired. Often traders measure volatility one of three ways; standard deviation, Beta and the volatility index.
What Is Time Value?
Time value, also known as time decay, is the price that an options contract shrinks to when it is closer to expiration.
Time value is a function of two variables, first being the remaining time until a contract reaches expiration and secondly being how far the strike price is in the money. Essentially, the longer the contracts the more value the option has.
What Is Intrinsic Value?
Intrinsic value is the value of the option in the current time. For stocks, the intrinsic is its actual value, meaning it takes out assumptions of what the stock or assets may be worth in future terms.
This value is a way for investors to determine what stock is best to invest in. It also represents the amount to be received by selling contracts.
What Is Extrinsic Value?
Extrinsic value consists of time value and the options implied volatility. When the options nears expirations, the extrinsic value will decrease, while when the contract is further from expiration the extrinsic value increases. You can measure this value simply by taking the difference in the value of the options contract (based on expiration) subratied by the market price of the option.
Why Would You Use an Option Premium?
Options give investors the opportunity to be apart of trades without having as much invested into the assets. This allows traders to be involved in a minimum amount of risk. Options premiums are beneficial for this and the fact that they are a tool to protect investments on multiple arrays of underlying security. This can lead to investors having extremely diverse portfolios that are sustainable in volatile markets.
What Are Option Premium Trading Strategies Used for?
Traders use strategies to aid in making proper moves to gain profit. The right strategies help hedge portfolios in market movements while benefiting from upward and downward market trends.
What Are Buying Calls?
Traders buying calls are entitled to the right but not obligation to purchase the underlying security at strike price. Typically traders purchase calls to have stake in the stock without needing large funds to be involved. Calls are bought when traders believe there is to be an increase in value over specified assets.
What Are Buying Puts?
Put options are a contract that gives buyers the right to sell a futures contract before the expiration date. Buyers will then need to buy a premium from the sellers of the options. While the options contract is at a set price, the premium will depend on the terms agreed upon by the two parties.
What Are Covered Calls?
Covered put options essentially allow us to purchase contracts at set prices that we anticipate will go below strike price. Covered put options protect from significant loss of value on shares we own.
What Are Bear Call Spreads?
Bear call spreads are an options strategy that can be used when options traders expect for a drop in the price of a particular asset. Essentially, traders will buy and sell a call with a similar expiration date. The goal when trading options with this strategy is to find assets that are believed to drop in value over time.
Bear spreads show a bearish trade which is when buying a put option and buying another put option that has a lower exercise price.
Factors Affecting Option Premiums
Let’s lay out the main factors that go into determine pricing of options premiums and how they individually dictate value.
Time value within options premiums is based on the amount of time left until expiration. When the options contract moves closer to expiration, the contract will then decrease in value.
Implied volatility changes depending on the activity in the options market. When implied volatility is high, the value of options is high.
When the strike price is set to increase, the call options price is set to decrease and the put option will rise.
The intrinsic value represents what the receiver will receive if the option is exercised that moment. Meaning by expiration what the option ends up being worth is the intrinsic value.
The higher the interest rate, the higher the option premium is set to be. When interest rates are averages higher traders are forced to make moves quickly as there is more competition for better premiums.
Are Option Premiums Right for You?
Options premiums are affected and determined by many variables. It’s important to understand how these variables work individually to pick the right options to invest into. With many questions being asked like, where do I even start. Financial advisors are a great asset to use when determining your business goals.