What is Option Premium?
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An option premium is the current market price of an option contract. It is thus the income received by the seller (writer) of an option contract to another party. In-the-money option premiums are composed of two factors: intrinsic and extrinsic value. Out-of-the-money options premiums consist solely of extrinsic value.For stock options, the premium is quoted as a dollar amount per share, and most contracts represent the commitment of 100 shares.
Definition
The option premium is the current market price of an options contract. It is the income received by the seller (writer) of the options contract from the buyer. The option premium consists of intrinsic value and time value.
Origin
The concept of option premium developed alongside the growth of the options market. Options trading dates back to the 17th century during the Dutch tulip mania, but the modern options market rapidly expanded after the Chicago Board Options Exchange was established in 1973.
Categories and Features
Option premiums can be categorized into in-the-money and out-of-the-money options. In-the-money options have premiums composed of intrinsic value and time value, while out-of-the-money options have premiums consisting only of time value. Premiums are typically quoted in dollar amounts per share, with most contracts representing a commitment of 100 shares.
Case Studies
A typical example is the stock options of Apple Inc. Suppose Apple's stock is currently priced at $150, and an investor buys a call option with a strike price of $140, with a premium of $15. This option is in-the-money because the strike price is below the market price, and the premium includes intrinsic value ($10) and time value ($5). Another example is Tesla Inc.'s stock options. Suppose Tesla's stock is currently priced at $700, and an investor buys a call option with a strike price of $750, with a premium of $20. This option is out-of-the-money because the strike price is above the market price, and the premium consists only of time value.
Common Issues
Investors often misunderstand the composition of option premiums, particularly the difference between intrinsic value and time value. Another common issue is neglecting the impact of time value, especially as the option approaches expiration, when time value can rapidly diminish.
