When you buy or sell an option, you pay or receive the "premium." Understanding what goes into this price is essential for making profitable trades. The premium determines your maximum risk when buying options and your potential profit when selling them.
What is Options Premium?
The options premium is simply the price of an option contract. It is quoted on a per-share basis, but since each contract controls 100 shares, you multiply by 100 to get the actual cost.
Example: An option quoted at $3.50 actually costs $350 per contract ($3.50 x 100 shares). This premium is what buyers pay to own the option and what sellers collect for selling it.
The Two Components of Premium
Every option premium consists of two parts:
Premium = Intrinsic Value + Extrinsic Value
Intrinsic Value
The real, tangible value based on how far the option is in the money. Only in-the-money options have intrinsic value.
Extrinsic Value (Time Value)
The additional value based on time remaining and volatility expectations. This is what traders pay for the "potential" of the option.
Example: Breaking Down Premium
Stock XYZ is at $75. A $70 call is trading for $8.00.
- Intrinsic Value: $75 - $70 = $5.00
- Extrinsic Value: $8.00 - $5.00 = $3.00
- Total Premium: $8.00 ($800 per contract)
You are paying $5 for immediate value and $3 for time and potential.
The Six Factors That Affect Premium
1. Stock Price
As the stock moves, the premium changes. For calls, higher stock prices mean higher premiums. For puts, lower stock prices mean higher premiums.
2. Strike Price
The relationship between the strike and stock price determines intrinsic value. Lower strike calls and higher strike puts have more intrinsic value.
3. Time Until Expiration
More time means higher premium. An option expiring in 60 days will cost more than the same strike expiring in 7 days because there is more time for favorable movement.
4. Implied Volatility (IV)
This is often the biggest factor in extrinsic value. Higher expected volatility means higher premiums for both calls and puts. Before earnings or major events, IV spikes and premiums increase.
5. Interest Rates
Higher interest rates slightly increase call premiums and decrease put premiums. This effect is usually small for short-term options.
6. Dividends
Expected dividends reduce call premiums and increase put premiums because the stock price drops by approximately the dividend amount on the ex-dividend date.
Most important factors: For most traders, stock price, time, and implied volatility are the three factors that matter most. These drive the majority of premium changes.
Why Premium Matters
For Option Buyers
- Premium is your maximum loss. If you pay $400 for an option, you cannot lose more than $400.
- The stock needs to move enough to cover the premium you paid to break even.
- Higher premium means higher breakeven point.
For Option Sellers
- Premium is your maximum profit. When you sell an option, the most you can make is the premium collected.
- Higher premium means more income but usually comes with more risk.
- Time decay works in your favor, eroding the premium you sold.
Example: Breakeven Calculation
You buy a $100 call for $4.00 premium:
- Breakeven = Strike + Premium = $100 + $4 = $104
- The stock must reach $104 for you to break even at expiration
- Below $104: You lose money
- At $100 or below: You lose the entire $400 premium
- Above $104: You profit (minus commissions)
How to Evaluate if Premium is Fair
Compare Implied Volatility
Look at the current IV versus historical IV for that stock. If IV is above its normal range, premiums are expensive. If IV is below normal, premiums are cheap.
Check the Volatility Skew
Compare premiums across different strikes. Usually, out-of-the-money puts have higher IV than calls (the "volatility smile"). Unusual skews can signal opportunity.
Use the Greeks
Delta, theta, and vega help you understand how sensitive the premium is to changes in stock price, time, and volatility.
Premium and Different Strategies
Long Calls and Puts
You pay premium upfront. Lower premium means less risk but usually requires bigger stock moves to profit.
Covered Calls
You collect premium by selling calls against stock you own. Higher premium means more income but limits your upside more.
Credit Spreads
You collect net premium by selling an option and buying a cheaper one for protection. The premium collected is your max profit.
Debit Spreads
You pay net premium by buying one option and selling another to reduce cost. Lower premium means better risk/reward if the trade works.
Example: Premium in a Spread
Bull call spread on stock at $50:
- Buy $50 call for $3.00
- Sell $55 call for $1.00
- Net premium paid: $2.00 ($200 per spread)
- Max profit: $5 - $2 = $3.00 ($300 per spread)
- Max loss: $2.00 ($200 per spread)
Common Premium Mistakes
- Buying expensive IV: Paying high premium before earnings, then suffering IV crush after
- Ignoring time decay: Not accounting for how quickly premium erodes
- Chasing cheap options: Low premium OTM options often expire worthless
- Not calculating breakeven: Failing to understand how far the stock must move
- Selling too cheap: Collecting tiny premiums for significant risk exposure
Track Your Premium Paid and Collected
Pro Trader Dashboard automatically calculates your premium paid, premium collected, and profit/loss on every options trade. See which strategies are most profitable for you.
Summary
Options premium is the price you pay or collect when trading options. It consists of intrinsic value (real value) and extrinsic value (time and volatility premium). Six factors affect premium: stock price, strike, time, IV, rates, and dividends. Understanding premium helps you evaluate whether an option is fairly priced and what the stock needs to do for your trade to profit.
Want to dive deeper? Learn about intrinsic value and extrinsic value separately.