Option premiums

What are options premium?

To start with the basic concepts, the premium paid represents the current market price of an option contract. There are two kinds of option contracts, “in the money” and “out of the money”. With in-the-money contracts, the premium is composed of 2 factors; the intrinsic and extrinsic value. Out-of-the-money contracts rely solely on extrinsic value.

An example of an in vs out of the money contract would be, purchasing a “call” option with Tesla that the price per share will reach 1000$ while it is trading at 1100$. Or inversely the out of the money option could be a “put” with UPST that the price per share will reach 90$ while currently trading at 109$. For stock options, the premium is a dollar amount per share representing the commitment to 100 shares per contract. So if the premium is 200 dollars per contract, the price is representing the option on 100 shares for the security of choice.

 

What affects the price of premiums?

The overall price of option premiums is composed of multiple factors. They include intrinsic/extrinsic value, time value, and the implied volatility of the security being purchased. With time value, each option contract will have an expiration date, as shown in the picture above. When purchasing an out of the money option for a call or put, the time remaining until expiration will be the primary value of the option. The more time remaining on a contract, the higher the time value will be, and vice versa as time remaining decreases so will the value. Contracts that expire the same day or close to the same day will be worth substantially less the further out of the money they are.

Now with the price movement of a security, if the price moves up, generally the value of a call option will increase as well, while put options will lose value. Their relationship is inversely related and will move according to how far in or out of the money the strike price on the contract moves.

What happens if the price remains flat?

When the price of the stock remains flat or remains constant for an extended period of time, theta decay will play a role in the value of the option. The theta decay is the percentage of the option premium that will be lost over time if the price does not change. This is different than if the price of the stock were to drop and you had a call option. Here everything is remaining constant, but as the contract moves close to expiration with no stock movement, the time value is eroded by the theta number associated with the contract held.

 

Implied volatility

For implied volatility, the effect lies with the extrinsic value of an option. The more volatile a stock is, the higher the implied volatility will be. A good example would be Tesla, it is known to have large swings in prices in both pre-market and open market time frames.  This means that it has a higher chance of reaching the desired strike price within the time alloted in the option contract. The implied volatility can increase the value for an out of the money position, given the higher probability the price can shift towards an in the money position.

When purchasing an option contract for a security, it is important to understand the factors that will affect that particular contract. Knowing how each affects the overall risk factor of the trade allows us as traders to decide if we should proceed with the investment or look at another option. You don’t want to get stuck with an option expiring the same day that is far out of the money with little to no volume. You may get stuck as one of the only holders of the contracts as the value heads to zero. While when considering volatile stocks like Tesla, it is important to always keep in mind the price swings can happen both ways. It can open at a -3% change in price but end the day +5% overall, having sell orders and stop-loss points can help trader’s accounts grow or survive at least for another day.

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