What you pay to own the option
In short:
An option premium is the price of an option contract. That is, the amount the option buyer must pay for the claim the option represent. Thus, the option premium is also the amount of income the option seller (writer) will receive for the contract.
The closer to in the money the options contract is, the more expensive the options premium will be. Also, the more time until the options contract expires, the more expensive the options contract will be as this means there is more time for the contract to become in the money.
Key Points
- An option’s premium is the price of the options contract.
- The closer the option is to being in the money, the more expensive the premium will be.
- The more time until the options contract expires, the more expensive the premium will be.
- The volatility of the options underlying asset will also impact the price of the premium as it will indicate the likelihood that the option expires in-the-money.
In-depth:
Understanding Option Premiums
Options represent a right to buy or sell an underlying asset at a set price within a specified amount of time regardless of what the price of the underlying asset does. Obviously, the ability to determine what price you would be willing to pay for an asset but not being obligated to buy it has some sort of monetary value.
Think of it like this, what if you could say I’m willing to buy Microsoft stock for $100/share but wouldn’t be obligated to buy the share unless they go higher than $100/share. That’d be a pretty easy way to make money since you have no risk of loss. If Microsoft shares drop to $90, it doesn’t matter because you’re not obligated to buy the shares.
The caveat here is that with options, you are buying the ability to do what we said above on someone else’s shares that they are willing to sell to you. For someone else to be willing to give you that right from above they would want monetary compensation in proportion to the risk they are taking.
This is where options premiums come in. Option premiums are the amount the buyer of an option is willing to pay for the right of the options contract and the seller is willing to accept for their risk.
More specifically, the risks or factors that go into determining an option’s premium are how close the option is to being in the money, the amount of time left until the option expires, and the volatility of the underlying assets price.
From these components, option buyers can determine the appropriate amount to pay for the options opportunity and sellers can determine what is appropriate for their risk.
Example, How Option Premiums Work
The premium paid for an options contract will be a factor in determining if the options trade is profitable or not. This is because to be profitable the option must be in the money and exceed the cost of the premium. Consider the put option example below.
Put example, say you were interested in buying American Express (AXP) 170.00 October 8 2021 puts. This would mean the strike price is $170. The current premium is quoted at $1.29 meaning the total premium for 1 standard contract is $129. Additionally, the current price for AXP is $173.94 with 5 days remaining until expiration.
Does buying this put option make money?
Fast-forward to expiration, AXP is now trading at $176.32 meaning the option is out of the money. It would not be wise to exercise the option.
Thankfully the maximum amount you could lose is $129, the price of the premium.
What would the math look like if you did exercise the option?
( Strike price – Current price ) * # Underlying assets – Option premium = Profit/Loss
( $170.00 – $176.32 ) *100 – $129 = -$761.
Factors of Determining Option Premiums
As mentioned above, there are three major factors to option premiums; how far the option is from being in the money (moneyness), the time until the option expires, and the volatility of the underlying asset.
The closer an option is to being in the money the more likely the option will end up in the money and therefore the more valuable the option is resulting in a higher premium. To be in the money for a call option, the price of the underlying asset must be greater than the strike price of the options contract. For a put option, the price of the underlying asset must be below the strike price of the options contract.
Nobody would sell an options claim to their assets indefinitely. If this were the case, why wouldn’t they just sell the underlying asset? Instead, options have an expiration date attached to them after which the option is no longer valid. The time between the purchase of the option and the expiration date represents a major source of value for the option. The more time given the more possibility there is for the option to be profitable and as a result, the premium will be higher.
Finally, the more volatility or movement in the underlying assets price the greater the chance the underlying assets price reaches the strike price and a profitable level for the options contract. As a result, options on assets that have more volatility will have higher premiums than similar options on assets with less volatility.