What is an option premium?

Let us understand the concept of option premium. However, before that, we need to understand the concept of options first. 

What is an option? 

An option is a derivative contract that gives the buyer of the option a right, but not an obligation to buy or sell an underlying asset on a future date and at a pre-determined price. This pre-determined price is called the exercise price or strike price. 

The individual buying the contract is known as the investor of the option. He has a choice to exercise his right. On the other hand, the individual selling the option is called the writer of the option. He has no right, rather, an obligation to fulfill the contract. That is, he is obligated to buy or sell an underlying asset in case the buyer of the option decides to exercise his right. 

An option contract is one of the derivative contracts, which is used as a risk management strategy by investors & traders to protect themselves against losses. 

What is an option premium? 

The market price that is paid by the buyer to the seller to purchase the option right is called the option premium. It is the sum of an option’s intrinsic value and time value, i.e. 

Option premium= Intrinsic value of the underlying+ time value of the contract. 

Here, intrinsic value refers to the difference between the current price of the underlying asset and the strike price specified in the contract. And the time value of the contract refers to the time period, in which, the option can be exercised. 

The option premium is a market-determined value and is influenced by three main factors: 

A) The price of the underlying asset,  

B) The volatility (or risk) level of the underlying asset, and 

C) The option’s time to expiry. 

Various option pricing models make use of these factors to determine the fair market value of an option. Black-Scholes Model, binomial model, and trinomial models are some of the popular models used for option pricing. A good understanding of all these concepts helps a trader to effectively incorporate an options strategy, and thereby, minimise his risks and maximise the profits.