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What Is an Option Premium? Definition and Related Terms

A premium is the sale price an investor pays to purchase an options contract from its writer or seller. Option premiums vary over time depending on several factors, including time until expiration, volatility of the underlying asset, and whether the contract has intrinsic value.
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Options contracts grant their holders the option to buy or sell an asset at a specific strike price on or before a specific date. The cost of an option contract is known as its premium. 

What Is the Premium of an Option Contract? 

An option contract’s premium is its market price. In other words, it’s how much an option buyer pays an option seller for an option contract.

An option contract is a derivative security that grants the buyer the right to buy (in the case of a call option) or sell (in the case of a put option) a collection of underlying securities (usually 100 shares of a stock) at a specific price on or before the contract’s expiration. Think of a premium as the sale price of an options contract.

Options are sold in groups of 100 shares, and a premium is paid for each of those shares, so a contract with a premium of $0.11 would cost the buyer $11 total, or $0.11 times 100 shares. Premiums change constantly depending on a variety of factors, including the intrinsic value of the underlying asset, the volatility of the underlying asset, and the amount of time remaining until the contract’s expiration.

What Factors Affect an Option’s Premium? 

A number of factors come together to determine the premium (or market price) of an options contract. The three most important are intrinsic value, the volatility or standard deviation of the underlying asset, and the amount of time remaining until the contract’s expiration.

Intrinsic value 

Intrinsic value refers to the value of an options contract if it were to be exercised immediately (e.g., a call option with a strike price of $60 would have an intrinsic value of $10 if the underlying asset was currently trading at $50 because the contract buyer could immediately exercise the contract for a $10 profit).

You can think of an option’s intrinsic value as the difference between its strike price and its market price (if advantageous to the buyer). In the case of a call, an option has intrinsic value if the strike price is below the market price. In the case of a put, an option has intrinsic value if the strike price is above the market price.

If an options contract has intrinsic value, it is considered “in the money,” and its intrinsic value is included in its premium. If an options contract does not have intrinsic value, it is considered “out of the money,” and its premium is based primarily on its time value and volatility, which together determine how likely the contract is to wind up “in the money” by the time it expires.

Volatility 

Volatility, also known as standard deviation, is the degree to which the underlying asset varies in price on a regular basis. The higher an asset’s volatility, the higher its premium, all other things considered. 

Time value

The time value of an option contract is based on how long remains until the contract expires. The longer a contract has until expiration, the higher its time value. When a contract is approaching expiration, little time remains for the underlying asset to change in value, whereas when a contract has months until its expiration, the underlying asset has plenty of time to change in value. Other factors aside, options have higher premiums the farther they are from expiration. It's also important to remember that time value decreases more quickly the closer a contract gets to its expiration. In other words, it decreases exponentially rather than linearly—this effect is sometimes called "time decay." 

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Other Factors 

The following also affect the premium of an options contract but to a lesser extent.

  • Dividend rate of the underlying equity
  • Supply of and demand for the underlying equity
  • Interest rates
  • Market conditions in general

How Is an Option’s Premium Calculated? 

In a general sense, the premium of an option contract is calculated by assigning dollar values to the time until expiration and the underlying asset’s volatility and adding these dollar values to the option’s intrinsic value. A simple formula, therefore, could look something like this:

Option Premium = Intrinsic Value + Time Value + Volatility Value

Other, less influential factors (like those listed under “Other Factors” above) may also be taken into consideration when calculating an option’s premium. 

Who Pays an Option’s Premium and When?

The premium of an option is paid by the buyer to the seller upon the sale of the contract—not at the contract’s expiration. Option premiums are not refundable. Options may be sold and resold many different times before their expiry, as most traders don’t actually exercise them. Many options traders buy options at one premium with the hope of reselling them for a higher premium later on based on price changes in the underlying asset.

Is It Better to Exercise an Option or Sell It for Its Premium? 

If an options contract has increased in value, it typically makes more sense to sell it for its higher premium than to exercise it and then hold or sell the underlying shares. Options have time value, whereas actual shares do not, so more gains can usually be realized by selling options for their premium (which includes their time value) than by exercising them and selling the resulting shares at market price (which does not include a time value).

If, however, the underlying asset has a substantial dividend payment coming up, it may make more sense to exercise the contract in order to receive the dividend payments guaranteed by ownership of the shares themselves. It’s important for investors to weigh their options and determine whether exercising or reselling an options contract would result in more substantial gains (or smaller losses) on a case-by-case basis.

How Are Option Premiums Taxed? 

Regardless of whether an investor exercises an option contract, the premium of that contract (its price) is considered part of their cost basis. In other words, it is deducted from their taxable gains or added to their deductible losses.

If an investor owns an options contract for more than one year before it expires or is resold, any gains or losses they incur are treated as long-term and are taxed accordingly (i.e., at a lower rate than normal income). Conversely, if an investor owns an options contract for less than one year before it expires or is resold, any gains or losses they incur are treated as short-term and are taxed accordingly (i.e., at the same rate as the investor's normal income).

More specific and complicated tax scenarios occur when investors use more complicated options-trading strategies like covered calls or protective puts. 

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