Option Premium

The premium is paid upfront when the option is bought. For the buyer, it is the maximum amount they can lose. For the seller, it is the maximum amount they can gain from selling the option, in exchange for taking on the obligation.

Option premiums are usually quoted per unit of the underlying asset. For share options covering 100 shares, a premium of 2.50 means paying 250 for one contract.

The premium has two parts. Intrinsic value is the amount by which the option is already profitable to exercise. Time value is the extra amount reflecting the chance that the option becomes more profitable before expiry.

Several factors affect the premium: the price of the underlying asset compared with the strike price, the time until expiry, the expected volatility of the underlying asset, interest rates and expected dividends. Higher volatility increases premiums, because larger price swings make a big payoff more likely. Longer time to expiry also increases premiums. Option pricing models, such as the Black–Scholes model, combine these factors to estimate a fair premium.