Option premium example, How are option premiums calculated?
Premiums are quoted on a per-share basis because most option contracts represent shares of the underlying stock. Intrinsic value, time value and implied volatility are the three components that determine the price of an option premium.
Intrinsic Value The intrinsic value of an option contract is the difference between the strike price and market price of the underlying stock. Time Value The time value of an option contract is dependent upon the length of time remaining before the option contract expires.
The more time option premium example option has until expiration, the greater the time value is. As the option approaches its expiration date, the time value decreases.
When the option expires, it becomes worthless. High implied volatility means that the market predicts that the stock will have large price swings in either direction.
Low implied volatility means that the market predicts that the stock will not swing in either direction significantly.
Higher implied volatility indicates a higher premium price. Whereas a lower implied volatility indicates a lower premium price.
Understanding how these three factors affect option premiums will prepare investors to differentiate between reasonable and unreasonable option premiums.