Option Premiums Explained

An option premium is the price that an investor pays for an option put option contract. The price of an option is made up of two parts: the intrinsic value and the extrinsic value.

The intrinsic value is the difference between the price of the underlying asset (such as a stock) and the strike price of the option. For example, if a stock is trading at $50 and you have a call option with a strike price of $45, then the intrinsic value of the option is $5. If the strike price is above the price of the underlying asset, then the intrinsic value is zero.

The extrinsic value, also known as the time value, is the portion of the option's premium that is due to the time remaining until the option's expiration and the volatility of the underlying asset. As the option gets closer to expiration, the time value of the option decreases. And a more volatile underlying asset will have higher extrinsic value.

It's important to note that the intrinsic value is only relevant for in-the-money options, which have an intrinsic value greater than zero. Out-of-the-money options and at-the-money options have an intrinsic value of zero and therefore their entire premium is made up of extrinsic value.

Options that give the holder the right to buy an underlying asset are called call options, and options that give the holder the right to sell an underlying asset are called put options. The premium for a call option will typically be higher when the price of the underlying asset is expected to rise and lower when the price is expected to fall. Conversely, the premium for a put option will typically be higher when the price of the underlying asset is expected to fall and lower when the price is expected to rise.

It's also worth noting that if the option gets exercised, the premium paid would be lost. This is why options are often considered as leverage instruments, as the potential gain (from intrinsic value increase) is higher than the premium paid but so is the potential loss (premium paid).