The premium is the price at which the contract trades. The
premium is the price of the option and is paid by the buyer to the
writer, or seller, of the option. In return, the writer of the
call option is obligated to deliver the underlying security to an
option buyer if the call is exercised or buy the underlying
security if the put is exercised. The writer keeps the premium
whether or not the option is exercised.
The option price is constitued of 2 price components, the
intrinsic value and the time value.
Option price = intrinsic value + time value
Intrinsic value: The intrinsic value of an option is the
difference between the actual price of the underlying security and
the strike price of the option.
The intrinsic value of an option reflects the effective financial
advantage which would result from the immediate exercise of that
option.
The intrinsic
value of an option reflects the effective financial advantage
which would result from the immediate exercise of that option.
|
Condition
|
Call
|
Put
|
|
Strike
price < underlying security price
|
In-the-money
Intrinsic
value >0
|
Out-of-the-money
Intrinsic
value = 0
|
|
Strike
price > underlying security price
|
Out-of-the-money
Intrinsic
value = 0
|
In-the-money
Intrinsic
value >0
|
|
Strike
price = underlying security price
|
At-the-money
Intrinsic
value = 0
|
At-the-money
Intrinsic
value = 0
|
The time value: It is determined by the remaining lifespan
of the option, the volatility and the cost of refinancing the
underlying asset (interest rates).
Time value =
option price - intrinsic value
Examples
| Option |
Strike |
Option Premium
|
Stock
|
Intrinsic Value
|
Time Value
|
| Call |
3 |
$3
|
$29
|
$1
|
$2
|
| Put |
50 |
$4
|
$52
|
$2
|
$2
|
| Call |
25 |
$2
|
$25
|
$0
|
$2
|
| Put |
100 |
$6
|
$101
|
$1
|
$5
|
| Call |
15 |
$1
|
$16
|
$0
|
$1
|
| Put |
40 |
$18
|
$55
|
$15
|
$3
|
Notice in the above examples that the intrinsic value plus
the time value equals the total premium of the option. |
