Definition Of Option Price/Option Premium

What is the option price or the option premium?

The option price is the amount that the option buyer pays to the option seller. Since options have an insurance character, the option price is also called the option premium. Note the subscription ratio or the multiplier of the respective option. For example, a stock option refers to 100 shares, which is why, when buying a stock option, the price of the option must be multiplied by 100 to obtain the actual amount to be paid. Depending on the underlying, futures options have different multipliers, which must be taken into account.

How is the price of an option determined?

Moneyness, time value, volatility & interest affect the option price

The price of an option is formed by supply and demand on the market. The current price of an option can be seen as a kind of estimate or bet by the market on how much the option is worth on average on the expiration date.

Factors influencing the option price

Thus, it is obvious that the price of the underlying and the strike price of the option (in other words, the moneyness) influence the option price.

However, since an option transaction is always associated with uncertainty regarding the value of the option on the expiration date, this circumstance is taken into account when pricing options.

If, for example, you expect a strong bullish movement of a share in the coming 12 months, you will be prepared to pay more for an option on this share with a remaining term of 12 months than for an option on a share with a remaining term of 2 months with a simultaneously low expected price potential.

Let us take a closer look at the individual factors influencing the option price:

Moneyness

On the expiration date, the value of an option is definitely calculable and corresponds to 100% of its intrinsic value; the time value is always 0.

The lower an option is in the money, the higher is its intrinsic value and accordingly the option premium. Options that are Out Of The Money are worthless on the expiration date.

Therefore, the following applies at all times, regardless of the remaining term:

The further an option is In The Money, the more expensive it is (with the same remaining term). The further an option is Out Of The Money, the cheaper it is.

Thus it can also be said:

  • The value of a call option increases if the underlying makes a bullish move. A bearish movement leads to a lower option price.
  • The value of a put increases if the underlying makes a bearish move and decreases in the case of a bullish move (assuming the circumstances remain the same).

Time value

The longer the remaining term of an option, the higher its time value. Therefore, the longer the remaining term to maturity, the more expensive an option on an underlying is for the same strike.

The time value of each option runs to 0 by the expiration date and thus decreases from day to day. This phenomenon is called time value loss.

Volatility

If the market expects the underlying to fluctuate widely, the price of an option will rise. Low implied volatility leads to lower option premiums.

Interest

Comparing the purchase of a share with the purchase of a call option on that share, the cost of the option is lower. The investor can theoretically invest the difference without risk. When pricing options, the financing costs are therefore also taken into account.

If interest rates for short-term financing rise, call options become more expensive and put options cheaper.

Key takeaways

  • The option premium/option price is the amount that the option seller receives from the option buyer.
  • Each option has a multiplier, which is multiplied by the option price.
  • The price of an option is influenced by the price of the underlying, the strike price, the time value, volatility and interest rates.
  • Options have an intrinsic and an external value.

Inner value and outer value

The option premium consists of the so-called intrinsic value and the external value or time value.

The intrinsic value can be calculated from the difference between the price of the underlying and the strike price, taking into account the subscription ratio (or multiplier).

The time value is based on the uncertainty regarding the development of the underlying and thus the uncertainty about the intrinsic value on the expiration date.

Trading with options

Options are ideal for private traders

If you want to trade profitably with options, it is important to know which factors influence the option price and to examine these before opening the trade.

Not only the price development of the underlying, but also the decline in fair value and the development of implied volatility have a strong influence on the option price. The influence of interest rates, however, can be neglected.

Key Takeaways

  • Successful options trading requires an understanding of the various factors influencing the option price.
  • By selling options, one can profit from the decline in fair value.
  • Selling options should be done at high IV, buying options at low IV.

Do not fight against time

The first question is whether options should be bought or sold.

In the best case, the buyer of an option can make a very high profit with a relatively small investment. However, the probability that this will often be successful is relatively low, since the option buyer is always fighting time due to the decline in fair value and therefore needs very good timing, and must make a very good assessment of how far the price of the underlying rises or falls.

The seller of an option can expect a very high hit rate depending on the strike chosen. However, the maximum profit is limited from the outset, whereas the maximum loss is theoretically unlimited. Risk management is therefore particularly important when selling options.

Since the decline in fair value is not linear, but depends on various factors such as remaining term, moneyness and volatility, this circumstance should be taken into account when buying and selling options. Thus, as a buyer of an option, you can keep the loss in time value low and as a seller of an option try to profit from it as much as possible.

The mean-reversion effect of volatility

Changes in implied volatility can have a very strong influence on the option price, even if the underlying does not move. The influence of the IV should therefore not be underestimated and should always be taken into account when choosing the option strategy.

Since volatility is subject to the mean-reversion effect and sooner or later always returns to its mean value, the sale of options should take place primarily at a high IV and the purchase of options primarily at a low IV.

Choosing the “right” strike

The choice of strike influences the price of the option, but should not be primarily based on it.

Imagine a stock is at 100 EUR and you buy a 150 call with a remaining term of 30 days. This call will be very cheap, but the probability that you will earn money with it is very low, because the stock should rise by 50% within a month.

The influence of the decline in fair value and volatility also depends on the moneyness and the choice of strike.

Read my other articles about options:

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