An option premium is the price of an option. Options contracts have a strike price which is the price at the contract will be settled, if exercised, on or before the contract expiration date. The difference between the current market price, the spot price, and the strike price is what makes for profit or loss in options trading. The options premium is paid by the buyer of the option to the seller. This gives the buyer the option but not the obligation to buy or sell the underlying equity if he or she so chooses. The value of the option premium is based upon how much the spot price varies from the strike price, volatility of the underlying equity, the amount of time left until expiration, as well as interest rates, stock dividends, and general market conditions. Traders pay premiums for buying puts and buying calls. Traders collect premiums for selling puts and selling calls. If the buyer exercises the option contract there is still that matter of buying stocks or under underlying equities, or selling them.
Also known as the option price or option value, the option premium represents the baseline cost of doing business in the options markets. If the trader buys options contracts and never exercises them he or she only pays the premium. If he or she sells options contracts and the buyer does not exercise the option then the only events are that the seller gains the premiums.
The option premium varies mostly with the price of the underlying equity. This involves very fundamental analysis. For example, when the trader buys call options for $3 a share on standard 100 share options contracts he or she pays $300 a contract. If the underlying stock goes up $3 a share the options trader is even. If it goes up more than $3 a share the contracts are “in the money.” The current price of the underlying equity, and whether or not the stock will pay a dividend, is two factors that directly affect option value. Other factors are the stock’s volatility, general market conditions, prevailing interest rates, and time left until contract expiration.
Market volatility and time left until the contact expiration date work together. Volatile stocks or futures will tend to have higher option premiums as there is a chance of the stocks or futures going up substantially. The longer the time left until expiration the longer time there is for the stock to make a move. With a non volatile stock and a short time left to expiration these factors have little effect on option value. It is with a volatile stock or future that the use of technical indicators such as used in Candlestick analysis come into play. The ability to accurately predict where the market will go can lead to substantial profits in options trading. General market conditions can lead to changes in option value and prevailing interest rates are often used as a comparison when looking at return on investment. An option on a very stable stock will not be very valuable if the trader is foregoing high interest rates on his or her money in order to trade.
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