What it means
Think of an option premium as the fee you pay to have the right, but not the obligation, to buy or sell a stock or other asset at a set price (the strike price) within a certain time period. It works like an insurance policy, giving you flexibility and protection against future price changes.
The amount you pay depends on several factors, chiefly how volatile the asset is and how much time is left before the option expires. The more the price tends to swing, and the longer the contract has to run, the more the premium costs, because there is a bigger chance of the option becoming valuable.
A premium has two building blocks. Intrinsic value is what the option would be worth if you used it right now, and time value is the extra the market charges for the chance that things improve before expiry.
An option that would not pay off today, known as out of the money, still carries a premium made up entirely of time value. For the buyer, the premium is the most they can lose, which is why options appeal to managers who want to cap their downside.
For the seller, called the writer, the premium is income received in return for taking on the obligation if the buyer decides to use the option. Paying an option premium is like paying a non-refundable deposit to hold a pair of concert tickets.
You pay a little now to secure your chance to buy the tickets later, just in case they become more expensive or sell out.
In practice
Real-world examples
Example 1
A bakery chain wants to fix the price of wheat for the next three months. It pays a $1,500 premium for the right to buy 100 tonnes at $300 per tonne. If the market price climbs to $360, the option saves it (360 - 300) x 100 = $6,000, leaving a net benefit of $4,500 after the premium.
Example 2
A small manufacturer is worried about rising steel costs. It pays a $4,000 premium for the right to buy 200 tonnes of steel at an agreed price. If steel prices fall instead, the company lets the option lapse and buys cheaper on the open market, so its maximum loss is the $4,000 premium.
Example 3
A software founder holds 1,000 shares in a listed company and fears a drop before a funding round. She pays a premium of $5 per share, or $5,000 in total, for put options that guarantee a minimum selling price. The premium is the price of peace of mind, and she knows the cost in advance.
Think of it
Buying an option premium is like paying a non-refundable deposit to hold a pair of concert tickets. You pay a little now to secure your chance to buy the tickets later, just in case they become more expensive or sell out.
Formula
Calculation
Option Premium = Intrinsic Value + Time Value, quoted per share or per unit of the asset. For a call option (a right to buy), Intrinsic Value = Current Price - Strike Price, or zero if that figure is negative.
Worked example: a share trades at $60, the strike price is $55, and the market charges $2 of time value.
Intrinsic Value = 60 - 55 = $5
Premium per share = 5 + 2 = $7
One contract usually covers 100 shares, so the total premium = 7 x 100 = $700.
If the share is still at $50 on expiry, the option expires worthless and you lose the $700 premium. If the share rises to $70, the option is worth (70 - 55) x 100 = $1,500, so your profit after the premium is 1,500 - 700 = $800.Case study
Seen in the real world
This is a fictional, illustrative scenario. Northwind Textiles needs 50 tonnes of cotton in four months, and cotton currently costs $2,000 per tonne. Worried about a price spike, the finance director pays a premium of $100 per tonne, or $5,000 in total, for call options that allow the company to buy at $2,000 per tonne. Four months later cotton has jumped to $2,400 per tonne. Northwind uses its options and buys at $2,000, saving (2,400 - 2,000) x 50 = $20,000 compared with the market price.
After subtracting the $5,000 premium, the net benefit is $15,000. Had cotton fallen to $1,800 instead, Northwind would have let the options expire and bought at the market price. Its effective cost would have been $1,800 plus the $100 premium, or $1,900 per tonne, and its loss on the options would have been limited to the $5,000 already paid. The finance director explained to the board that the premium was simply the price of certainty, much like an insurance premium on a warehouse.
Watch out
Common mistakes
- Confusing the premium with the strike price, when the premium is only the fee for the right and the strike price is what you pay if you use it.
- Expecting the premium back if the option is never used, when it is non-refundable and belongs to the seller from day one.
- Choosing the cheapest option without checking the expiry date, since a short-dated option is cheap precisely because there is little time for the price to move.
Questions
People also ask
Who receives the option premium?
The seller, also called the writer, keeps it regardless of what happens next, as payment for taking on the obligation to deliver or buy if the buyer uses the option.
What makes an option premium go up?
Higher volatility in the underlying asset, more time until expiry and a strike price closer to (or beyond) the current price all push the premium up.
Is an option premium the same as an insurance premium?
The idea is similar, because you pay a known cost to limit a risk, but an option can also let you profit from favourable moves, which a standard insurance policy does not.