Option premiums explained

What is an option premium?

An option premium is the price that traders pay for a put or call options contract. When you buy an option, you’re getting the right to trade its underlying market at a specified price for a set period. The price you pay for this right is called the option premium.

The size of an option’s premium is influenced by three main factors: the price of the underlying market, its level of volatility (or risk) and the option’s time to expiry.

When you spread bet or trade CFDs with IG, you don’t pay a traditional option premium. Instead, you’ll put down margin. The terms ‘premium’ and ‘margin’ are used interchangeably when referring to options trading with IG.

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How are option premiums calculated?

Option premiums are calculated by adding an option’s intrinsic value to its time value.

So, if a call option has an intrinsic value of £15 and a time value of £15, you’ll need to pay £30 to purchase it. To make a profit from the option, you’ll need to exercise it when the underlying market is more than £30 over the strike price.

Option premiums and intrinsic value

Intrinsic value is the difference between the option’s strike price and the current price of the underlying market. For call options, intrinsic value is calculated by subtracting the strike price from the underlying price. For put options, the opposite is true – intrinsic value is calculated by subtracting the underlying price from the strike price.

Say you’re considering purchasing an option to buy ABC stock for £44 when it is currently trading at £50. You’d be able to exercise your option and make £6, so the option’s intrinsic value is £6. If ABC stock dropped below £44, the option’s intrinsic value would be £0.

Option premiums and time value

Time to expiry also affects an option premium’s time value. The longer an option has before it expires, the more time the underlying market has to pass the strike price, and vice versa. Continuing our example above, say you were choosing between two call options on ABC stock with the same strike price but different expiries. You might consider paying more for the option with the longer expiry, as it gives more time for you to exercise the option at profit.

Falling time value is known as time decay, a risk that options traders need to manage. As an option nears expiry, time decay means that its value will drop.

Another key aspect of time value is the market’s implied volatility. A more volatile market is more likely to move beyond the strike price, which means volatile markets will often come with higher premiums.

You can calculate an option’s time value by subtracting its intrinsic value from its premium.

Say ABC stock’s market price is £50, and you buy a call option with a strike price of £44 for a £200 premium. The intrinsic value will then be £6 (£50 – £44) and the time value would be £194 (£200 – £6).

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The Greeks and option premiums

The Greeks – namely delta, gamma, theta, vega and rho – are measures of the individual risks associated with trading options. These units can help you calculate the risk involved with each of the variables that affect option prices.

• Delta: How sensitive an option’s price is to the movement of the underlying market. Learn more about delta
• Gamma: How much an option’s delta moves for every point of movement in the underlying market. Learn more about gamma
• Theta: How much an option’s price decays over time. Learn more about theta
• Vega: An option’s sensitivity to volatility in the underlying market. Learn more about vega
• Rho: How much interest rate changes will move an option’s price. Learn more about rho