Major Factors Determining Option Premiums

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An option premium refers to the current price of an option contract in the market.

This price includes the underlying asset's intrinsic value, time value, and implied volatility. A change in any of these elements would change the option premium. There are a few major factors that influence option premiums quite often.

If you want to trade options, you need to understand how the premium is set to determine if the price of an option contract is appealing.

If the volatility of the underlying asset is going to increase dramatically during the contract period, you may find the option appealing based on the current premium. You can do that by assessing the following factors.

Strike Price

You may already know the concept of strike price in options trading. It determines whether an option has intrinsic value.

The option premium, which includes inherent value, usually rises as the option moves further in the money. The option price goes down as the option goes more deeply out-of-the-money.

Underlying Price

The value of an option may increase or decrease depending on changes in the underlying security price. Usually, price changes have opposite impacts on calls and puts.

A call option generally increases when the underlying security's value increases. However, the set value usually decreases in price. On the other hand, the exact opposite happens when the underlying security value falls.

Time Until Expiration

Time value, as mentioned earlier, is a component of the option premium. The time until expiration significantly affects the time value, influencing the option premium.

The levels of an option’s time value usually decrease for both calls and puts as the time of expiration approaches. Such an impact on the option premium is more noticeable with at-the-money options.

Implied Volatility

Since the impact of implied volatility is subjective, it is generally difficult to quantify. More often than not, it significantly impacts the time value component of an option premium. As you may know, volatility measures uncertainty (risk) or variability in an option's premium.

With higher volatility estimates, one can expect greater fluctuations (in either direction) in the underlying price levels. Such expectations generally lead to higher option prices for both puts and calls. This impact is also more noticeable with at-the-money options.

Dividends and Interest Rates

The dividends of the underlying security and the current risk-free interest rate have a small yet measurable impact on the option premiums. This impact indicates the cost of carrying shares in an underlying security.

In case you don’t know, the cost of carrying is the potential interest given for margin or received from the alternative investments you have made and the dividends you receive from directly owning shares. Pricing also depends on the hedged value of an option.

Understanding the Components of an Option Premium

To understand the impact of the aforementioned factors on option premiums, you need to know how the major components of option premiums work. Proper knowledge of these components will help you make the right investment decisions.

Intrinsic Value

The intrinsic value of an option is the difference between the price of the underlying financial asset and the option's strike price. For call options, you can estimate the intrinsic value by subtracting the contract's strike price from the underlying asset's market price.

Time Value

An option contract's time or extrinsic value relies on the time until expiration. The farther an option contract is from its expiration, the higher its extrinsic value. The time value of an option contract also drops quickly as the expiration date approaches.

Volatility

You should always measure the underlying financial instrument's volatility using the standard deviation concept. A higher level of volatility means a higher premium for put or call options.