Premium is the price paid or received for purchasing and selling options, respectively. Premium price has two components:
- Intrinsic Value
- Time Value
Option premium = Intrinsic value + Time Value
Intrinsic value is the amount by which the strike price of an option is in the money.
Call Option Intrinsic Value = Current Stock Price – Call Strike Price.
If the above value is positive, then the option is ‘In the money’. If it is negative, then the option is ‘out of the money’ and if it zero, it is ‘at the money’
Put Option Intrinsic Value = Put Strike Price - Current Stock Price
If the above value is positive, then the option is ‘Out of the money’. If it is negative, then the option is ‘In the money’ and if it zero, it is ‘at the money’
For more on intrinsic value, refer https://www.sptulsian.com/article/83295/what-is-meant-by-intrinsic-value-
Time value is the difference between premium and intrinsic value. Thus, at-the-money and out-of-money options will have only time value, as their intrinsic value is zero.
For more on time value, refer https://www.sptulsian.com/article/83296/what-is-meant-by-time-value
Other factors affecting option premium:
- Price of underlying: Any fluctuation in the price of the underlying (stock/index/commodity) has the largest impact on premium of an option contract.
- Volatility of underlying: The degree by which its price fluctuates can be termed as volatility. Higher volatility increases the option premium because of greater risk it brings to the seller.
- Strike price: How far is the strike price from spot also has an impact on option premium.