Options 101: Premium

A premium is a common term that is crucial to know when it comes to options trading. It refers to the price for which a trader buys or sells an options contract.

Value, Time, Volatility

A variety of factors determine premiums. The most important include:

— The intrinsic value of the option. When an option is in-the-money, the intrinsic value is the difference between the market price of the underlying security and the option’s strike price. When an option is out of the money, the intrinsic value is $0.

— The time value of the option. Time value decreases as the expiration date nears. This is because there is less time for the intrinsic value to increase. Time value reaches $0 on the option’s expiration date.

— The implied volatility of the option. The portion of the premium associated with the implied volatility will increase as the volatility of the underlying security increases. This is because the chance of reaching the strike price is higher for more volatile securities.

Several formulas determine options premiums, including the Black-Scholes formula. This is the best known, and its importance has been recognized with a Nobel Prize in Economics.

In the most simplified terms, the premium can be found with an equation that considers several factors:

Premium = Intrinsic Value + Time Value + Implied Volatility

To find the intrinsic value of the option, find the difference between the market price of the underlying security and the option’s strike price. For a call option, subtract the strike price from the current market price of the underlying security. A call with a strike price of $10 on a stock, for example, with a market price of $15, has $5 of intrinsic value. For a put option, subtract the market price of the underlying security from the strike price. A put with a $12 strike price on a stock with a market price of $9 has $3 of intrinsic value. Again, the intrinsic value for out-of-the-money options is $0.

Determining the time value and implied volatility is more difficult. There are a number of calculators available on different websites and in software packages that can do this.

Why Premium Matters To Traders

Premium helps traders determine the potential profits on a trade.

When buying options, most traders begin their analysis by finding securities they expect to see large price moves in. They will then review the available options contracts on that security, comparing the actual premiums to what they believe the premiums should be. Like investing in stocks, value is an important consideration. Buying undervalued options would be preferable to buying overvalued options.

Traders may determine what the premium will be when they close the trade. They calculate the expected profit and consider the risk of the trade. For buying options, this is limited to the premium paid per contract. Successful traders usually pick the trades with the best reward-to-risk ratio, based on the premium and expected premium.

When selling options, the premium is the amount the seller is paid for accepting the potential obligation of having to buy or sell the underlying stock at the option’s strike price. Many options sellers look for overpriced options to sell to increase the amount of income they can generate with this strategy. If the option expires worthless for the options buyer, then the seller gets to keep the premium as their profit.

The bottom line: Premium is important to traders because, as the market price of an options contract, it determines the trader’s profits. Overpaying for a buy or accepting too little premium when selling can decrease profits.

P.S. Want to know how to use options premiums as “insurance” on your portfolio? Our colleague Amber Hestla will show you how…

By using one of the most conservative options strategies around, Amber and her followers over at Maximum Income are using these trades like an “insurance policy” — generating premiums for immediate income, while still giving you the chance to profit on the upside…

This is about as close as it gets to a “win-win” when it comes to investing, and we think every investor should at least know how it works.

That’s why she’s created a special briefing, which explains how this “market insurance” works. Go here to check it out now.