Options Premium

The price paid to acquire the option. Also known simply as option price. Not to be confused with the strike price. Market price, volatility and time remaining are the primary forces determining the premium. There are two components to the options premium and they are intrinsic value and time value.

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Intrinsic Value

Intrinsic value is the value of an option’s immediate exercise payoff. For a call, it is the amount the underlying price exceeds the strike; for a put, it is the amount the strike exceeds the underlying price. If that difference is negative, intrinsic value is zero. Only in-the-money options have positive intrinsic value. Out-of-the-money and at-the-money options have zero intrinsic value.

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Time Value

An option's time value is dependent upon the length of time remaining to exercise the option, the moneyness of the option, as well as the volatility of the underlying security's market price.

With other pricing factors held constant, the passage of time generally reduces the value of a long option. This is known as time decay. The market premium does not have to fall each day: stock movements and changing implied volatility can outweigh decay. At expiration there is no remaining optional life; any exercise or settlement value follows the contract terms.

Time value, also called extrinsic value in this context, is the option price minus intrinsic value. For out-of-the-money options, intrinsic value is zero, so the entire premium is time value. The amount varies with moneyness, volatility, time remaining, rates, dividends and exercise style; it is not guaranteed to decrease monotonically as an option moves deeper into the money.

Typically, higher volatility give rise to higher time value. In general, time value increases as the uncertainty of the option's value at expiry increases.

Effect of Dividends on Time Value

Time value of call options on high cash dividend stocks can get discounted while similarly, time value of put options can get inflated. For more details on the effect of dividends on option pricing, read this article.

Premium example

Suppose a stock trades at $45 and its $40-strike call trades at $6 per share. Intrinsic value is $5 and time value is $1. For a standard 100-share contract, the option costs $600 before fees. Paying the $600 premium does not buy the shares: exercising the call would require a separate $4,000 share purchase.