What is an options premium?

An options premium is the price that an investor pays to buy an options contract or the amount received by the seller (or writer) of the options. In options trading, this premium reflects the current market price of the options and is one of the essential components in the process.

Futures and options trading rely heavily on understanding the options premium, which consists of two parts: intrinsic value and extrinsic value. Intrinsic value is the difference between the underlying asset's current price and the strike price if the options are in the money (ITM). Extrinsic value, also known as time value, accounts for factors such as the time remaining until expiration and the asset's volatility. Understanding these elements is vital when considering futures and options trading strategies, as they directly influence the premium's value.

The options premium fluctuates due to various factors, including market sentiment, time decay, and volatility, all of which can affect the options' overall cost. This blog will discuss the components of an options premium and offer a clear understanding of how it is calculated.

What are the components of an options premium?

The options premium consists of two primary components: intrinsic value and extrinsic value.

• Intrinsic value refers to the value that exists when the options are ITM. For example, if a call option has a strike price of ₹1,000 and the underlying asset is trading at ₹1,100, the option has an intrinsic value of ₹100. This value represents the actual financial gain the holder would receive by exercising the option.
• The extrinsic value represents all the external factors that influence the premium price, such as the time until expiration and volatility. This value decreases as the expiration date approaches, a process known as time decay.

For options that are out-of-the-money (OTM), the premium will consist solely of extrinsic value since there is no intrinsic value. That's why understanding the breakdown of the options premium is essential for traders in the futures and options trading market.

How is the options premium calculated?

The calculation of options premium is determined by different factors. These variables feed into complex pricing models, which are often used to determine the theoretical price of options.

• Intrinsic value calculation: For a call option, the intrinsic value is calculated by subtracting the strike price from the current price of the underlying asset. In the case of a put option, the intrinsic value is the positive difference between the strike price and the current asset price. If the result is negative, the intrinsic value is zero.
• Extrinsic value calculation: This part of the options premium calculation is more intricate and depends heavily on time to expiration and volatility. As expiration nears, the extrinsic value shrinks, while implied volatility can significantly increase the options price if the underlying asset is expected to move sharply.

What are some examples of options premiums?

An options premium example can help clarify how these components work in real-world scenarios. Let's consider call options with a strike price of ₹1,000 while the underlying asset is currently trading at ₹1,100. The intrinsic value of options is ₹100.

Now, if the time to expiration is 30 days and the market volatility is high, the extrinsic value could be an additional ₹50. Hence, the total options premium would be ₹150 (₹100 intrinsic value + ₹50 extrinsic value). This total premium must be paid by the buyer to purchase the options.

Alternatively, if the options were out-of-the-money (for example, if the strike price were ₹1,200 while the asset is trading at ₹1,100), there would be no intrinsic value. The premium would solely consist of extrinsic value, which may be ₹30 based on market conditions. Hence, the premium would be ₹30. This breakdown is critical when considering online trading strategies.

What factors affect the options premium?

There are several factors that influence the price of options, making it dynamic in nature. Key factors include:

1. Underlying asset price: The movement of the underlying asset's price has a direct effect on the options premium. If the asset price moves favourably for the holder of the options, the premium typically increases.
2. Moneyness: This refers to the options' intrinsic value. Options that are ITM have a higher premium due to their immediate potential profit.
3. Time to expiration: The longer the time until expiration, the greater the extrinsic value. This is because more time allows for the asset's price to potentially move in a direction that benefits the holder of the options.
4. Volatility: Increased volatility raises the likelihood that the options will move ITM, thereby increasing the premium. Higher implied volatility results in a higher extrinsic value, while lower volatility has the opposite effect.

Why is understanding the options premium important for traders?

Understanding options premium is crucial for traders in futures and options trading. It provides a clear picture of the costs involved in buying or selling options, which is critical when formulating trading strategies. The premium is affected by intrinsic value, extrinsic value, time to expiration, and market volatility. Mastering the concept of options premium calculation can significantly improve a trader's ability to manage risk and make informed decisions in online trading environments.