Understanding Options Premium
Options premium is a term that gets used very frequently in options trading, so it's definitely something that you need to understand. Unfortunately it's also a term that can cause a great deal of confusion because it's often used to mean two different things. Although the meanings are closely related, if you see or hear the term options premium and don’t know in what context it's being used, it can lead to misunderstandings and possibly trading mistakes.
On this page we look at the two different ways in which the phrase is used.
- Premium meaning Price of an Option
- Premium meaning Extrinsic Value of an Option
Premium Meaning Price of an Option
When you buy options contracts you have to pay the ask price, and when you write them you receive the bid price. The ask price and the bid price of contracts at any given time can be found by checking on the exchanges or looking at the options chains that your broker will provide. The term option premium is often used by traders, experts, and financial commentators to basically refer to either the price that you pay to buy or price you receive for writing.
For example, if you were buying contracts at a cost of $2, then you could be said to be paying a premium of $2. Along the same lines, if you were writing contracts at $1.80 then you could be said to be receiving a premium of $1.80.
In this sense, the phrase options premium is really quite simple. It's essentially just another word for price; you pay a premium to own a contract and you receive a premium when you write a contract. However, premium has a second meaning that is related to the way options are priced using two components: intrinsic value and extrinsic value.
Premium Meaning Extrinsic Value of an Option
The price of an option can be broken down into two parts. Any inherent profit that is built in to the contract is one part of the price, and is known as intrinsic value. As an example, a call with a strike price of $20 on an underlying stock that is traded at $22 would have $2 of intrinsic value, because the call could theoretically be exercised to buy the stock at $2 less than the current worth of that stock.
The second part of the price, extrinsic value, essentially serves as the actual cost of owning options, and represents compensation to the writer of contracts for the risk they are taking. If the previously mentioned call was trading at $3, then the extrinsic value is $1: the total price minus the intrinsic value. Where there is no intrinsic value (i.e. no inherent or built in profit) then the price is made up entirely of extrinsic value.
Options premium is often used to refer to the extrinsic value rather than the overall price. This is because it's the extrinsic value that is the real cost of owning a contract, and is the real value gained by writing a contract. For example, if you bought the above mentioned call options at $3, you are only effectively paying $1 for the right to own them as the other $2 you are paying represents the built in profit. If you were writing them for and receiving $3, then you would only technically be gaining the $1 for the same reasons.
In these examples, that $1 could be referred to as the premium by those that use the term to mean extrinsic value.
The difference between the extrinsic value of an option and the whole price can be significantly different, and the diverse meanings of the term premium can cause problems. Most terminology and phrases that are used in finance and investment have a standardized meaning, precisely to avoid such potential confusion. However, premium just happens to be a phrase that has these two different meanings.
This doesn’t have to be a major problem for you, but it's absolutely imperative that you recognize that the term can be used in two different ways. When reading about creating options spreads and using certain trading strategies, if the term premium is used you should always ensure that you are absolutely clear whether it's referring to the whole price of an option or just the extrinsic value.