Options are a good way to diversify your portfolio and create a barrier to avoid losses. All it takes is commitment to make significant gains in the market without the help of short selling shares. There are several aspects to an option, but an Option Premium is one of the most important one from the seller’s point of view. Everything you need to know about an Options Premium will be covered in this article.
Options in a Nutshell
Options are a type of derivative. It is a contract that gives the buyer of an options contract the right to buy or sell an underlying asset or assets at a pre determined price, depending on the type of options he possesses. There are two types of Options, “Call option” and “Put option”.
A call option refers to the right to buy an underlying asset or assets at a pre determined price called “strike price”. A put option gives the right to the buyer to sell an underlying asset at the strike price.Unlike futures contracts, in both the options types, the seller of the options contract has no right but merely an obligation to follow suit of the buyer’s wish. The seller receives a compensation or income in return, known as an “Options Premium”.
What is an Option Premium?
An Options Premium is the total value of the contract received by the seller.This value shouldn’t be confused with strike price, and is also simply called “options price”. It a seller’s income for selling the contract and does not come back to the buyer in any mode. Any Options premium once paid is non-refundable. The value of options price/premium is calculated on a per- share basis.
Factors Affecting Options Premium
There are three factors that affect options premium:
- Value of the Underlying Asset:
The price of an underlying asset influences options premium. If the price of the asset increases, the value of the premium also increases in case of a call option. However, in case put options, the premium would fall, being affected inversely.
- Market Value:
The price of an option at the spot market affects the premium because it shows the gap between the strike price and spot price on an underlying asset.
Implied volatility is useful to determine how volatile stocks price my get in the future. It is derived from the price of an option and is plugged to the option’s pricing model. Volatility affects the extrinsic part of options price.
- Time Remaining before Expiry:
The time left until an option expires affects the time value part of the options premium. The options premium is close to the intrinsic value the closer it gets to the expiration date.
Components of an Option’s Premium
- Intrinsic Value:
The intrinsic value of an option contract is just the difference between the strike price and the market price of the underlying asset. For example, if the strike price is Rupees 100 per share and the market price is valued at Rupees 125, one can reap a profit of Rupees 25 per share by immediately buying the call. 25 Rupees is the intrinsic value of the option.
In a case where the market price of the share is valued at Rupees 85 instead, there is no intrinsic value and the option is out of money in the market. In such a case, the time value of an option makes an important difference.
- Time Value:
In the event of an options contract being “out of money” the time period of the contract till its expiry makes a difference. This is because there might be significant changes in the price of the asset in the future. This is what time value on an options contract means; it is the price an investor is willing to pay above the intrinsic value of options for a future return.
For example, when the strike price was Rupees 100 for a market value of 85, it would be wise for the holder to wait a period of a month or two, when the market prise would rise to 150.
If the options already have an intrinsic value, say, Rupees 20 per share, the buyer could hold his call to buy for some time till the price reached Rupees 130 as a market value, thereby giving an additional Rupees 10 worth gain to the seller.
Options Premium = Intrinsic value (Rs 20/share) + Time Value (Rs 10/share) = Rs 30
You can also read- What are Futures & Options?
An option’s premium is subject to constant change according to the market fluctuations. Another factor to be considered is to keep a close watch on the time decay. The closer the contract is to expiring, the lesser the premium will be. Options are a risky investment but pay off in the long term. Hence it is advised that options are more suitable for seasoned and experienced investors in the market. You can learn more by reading as much as you can. Visit our blogs to read articles based on stocks and financial investments by Indira Trade Blog. The more information one has, the better they trade!