The option premium is the price one has to pay to acquire the option. It is also known as the option price. Where does one find information on the option premium? For this, do refer to an options chain.
This is the November 2015 options chain for Cisco Systems Inc. At the point of this writing, It was November. This would be consider a current month option chain.
To find out the options premium, look at the bid and ask columns of the option. The left side of the options chain represent the call options while the right side of the option chain represents the put options. So If you want to find out the option premium for the call options, look at the bid ask columns on the left.
If you want to find out the call option premiums, look at the bid and ask columns on the right.
Why look at the bid and ask prices? The bid prices represents the option premium that one gets when he sells the option while the ask prices represents the option premium that the one has to fork out to buy the option.
What influences the value of the option premium? The option premium is determined by the time to expiry, the underlying security price, the exercise price and the price volatility of the underlying security. These 4 factors always have a hand in determining the option premium or the option price.
Intrinsic value
Only in the money options have intrinsic value. Out of the money options do not have intrinsic value. Intrinsic value is the difference between the price of the underlying security and the exercise price. Hence, intrinsic value differs for options of different exercise prices.
Let us take a look at an example.
This is the options chain for Tesla Motors Inc. It trades at $208.35. Hence if you look at the call options with an exercise price of $207.50, the intrinsic value is $208.35 – $207.50 = $0.85 To calculate the intrinsic value per options contract:
$0.85 x 100 = $85
The intrinsic value of this option contract is $85. Each option contract has an underlying security of 100 shares.
Intrinsic Value Of A Call Option = Underlying security Price – Exercise Price
Intrinsic Value Of A Put Option = Exercise Price – Underlying security price
This is an options chain on Citigroup. Those portions shaded blue represent the options that are in the money. At the time of this writing, the trading price of Citigroup is $54.16. Call options with strike(exercise) prices of $54 and below are in the money call options. Put options with exercise prices that are greater or equal to $54.50 are in the money put options.
A call option is in the money when the underlying security price is greater than the exercise price. On the other hand, a put option is in the money when the exercise price is greater than the underlying security price.
Time value
The time value is a monetary value on the time to expiry of an options contract. So let us look at an example.
This is the same options chain for Tesla Motors Inc as above. It’s current market price is $208.35. We are observing the call options with a strike price of $207.50. The intrinsic value is $208.35 – $207.50 = $0.85
But for that particular call option at a strike price of $207.50, the option premium is $13.05 when you look at the ask price.(When you are an option buyer, the ask price is the indicative price that you can buy the options at.)
The time value is calculated as such:
$13.05 – $0.85 = $12.20
The greater the time to expiry of the option, the greater the time value. This is because if there is much time left to expiry, there is a greater probability that the option premium or the option price will increase. This is especially so if the price of the underlying security is volatile.
As an option approaches its expiration date, the time value will decrease to zero. This is termed as time decay. Options are essentially wasting assets.
Read : How To Mitigate The Effects Of Time Value Decay
Relationship between intrinsic value, time value and the strike(exercise) price
The intrinsic value and time value are the major determinants of the option premium. The greater the time left to expiration date, the greater the time value. Intrinsic value is determined by the difference between the exercise price and the underlying security price.
Option Premium = Intrinsic Value + Time Value
Dividend payouts by companies can affect option prices
Company A is planning to pay a dividend. When a dividend is paid, the stock price and the market capitalisation of the company is adjusted for the dividends paid. If a company trades at $10 per share and decides to give a $2 per share dividend, it’s stock price will adjust to $8 on ex-dividend date.
As a result, call option prices tend to be lower in the weeks before an anticipated dividend payout and put option prices tend to be higher in the weeks preceding an anticipated dividend payout.
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