Home/Blogs/Understanding the Concept of Option Premium

Understanding the Concept of Option Premium

26 Jun 2023

Introduction

Investors embrace options because of their ability to leverage market strategies. If investors expect a rise in stock, they purchase a call option so that they can buy shares at a discounted price later. This way, they gain substantial profits if the stock performs.

Simultaneously, if they seek risk mitigation during unexpected stock declines, they buy a put option to sell at a predetermined price, limiting losses. Comprehending the option premium is vital for investors looking for successful long-term outcomes. It encourages informed decision-making and helps make the most of advantageous opportunities.

Let's learn about option premiums in detail.

What is an option premium?

The option premium refers to the price paid for acquiring an option contract. It represents the cost of obtaining the right, but not the obligation, to purchase or sell the underlying asset at a specified price within a predetermined range. The premium is influenced by factors like the asset’s price, volatility, time to expiration, and interest rates. This way, it truly reflects market expectations and perceived risks.

What are the factors affecting an option premium?

The factors influencing option premiums are as follows:

Intrinsic Value

The intrinsic value of an option represents the potential profit attainable upon immediate exercise. It is determined by the positive difference between the current market value of the asset and the strike price. For instance, if an investor purchases a call option for XYZ company with a strike price of Rs. 45 and the stock is currently valued at Rs. 50, the option possesses an intrinsic value of Rs. 5.

In this scenario, one could exercise the call contract and receive Rs. 500 (Rs. 5 x 100 shares). This condition is referred to as being 'in the money'. On the other hand, if the market value is only Rs. 40, the option holds no intrinsic value, classifying it as 'out-of-the-money'. The duration of the contract influences the second component of the option premium.

Open Your free Demat Account in just 5 minutes!

Extrinsic Value

The intrinsic value, also referred to as time value, is the difference between the option premium and the intrinsic value. It represents the potential for the underlying asset’s price to move favourably. As the contract approaches expiration, the extrinsic value diminishes.

Factors that impact extrinsic valuation are time and implied volatility. Longer contract durations make predicting asset price movements more challenging. Historical volatility measures past price changes, while implied volatility gauges expected future changes. Higher volatility implies greater price swings and risk, positively affecting option premiums. As expiration nears, extrinsic value’s impact on option premium becomes negligible until it vanishes.

Black-Scholes Option Price

The widely used Black-Scholes option pricing model incorporates various data points. It includes option price, strike price, interest rate, underlying security price, expiration time, and implied volatility (IV). Implied volatility is not directly observable; it requires all five data points to be known beforehand for calculation using the model. It is derived by back-calculating using the mathematical formula.

The Black-Scholes formula calculates the price of a Call option as follows:

C = S * N(d1) - X * e^(-rt) * N(d2)

For a put option, the formula is:

P = X * e^(-rt) * N(-d2) - S * N(-d1)

Where,

S= underlying asset price

X= Strike price

t= Expiration time

r= Interest rate

N (d1) and N (d2) = cumulative standard normal distribution functions

The various components in option pricing equations are represented by the option Greeks. It includes Delta, Vega, Gamma, Rho, and Theta. These option Greeks collectively form the intangible part of intrinsic value. They measure the option price’s sensitivity to changes in the underlying price, volatility, interest rate, and time to expiration.

Conclusion

Options offer diverse strategies for experienced investors, accompanied by inherent risks. When you are familiar with the pricing factors, particularly volatility, it enhances the likelihood of achieving higher returns. However, you should delve into understanding the option Greeks, like Delta, Gamma, Theta, Vega, and Rho, to gain a comprehensive grasp of the option premium and its dynamics.

 

Related Articles: Using futures as a form of Margin Trading in Stocks | How to Place a Margin Trade On the MO Trader App | The importance of operating margins for a company

Checkout more Blogs

You may also like…

Get Exclusive Updates

Be the first to read our new blogs

Intelligent investment insights delivered to your inbox, for Free, daily!

Open Demat Account
I wish to talk in South Indian language
By proceeding you’re agree to our T&C