What factors affect an options contract’s premium?￼
While researching options derivatives contracts, you might have come across the term options premium. It forms a significant part of your total budget when purchasing options, and you need to be aware of what it is and the factors that affect its value.
Find out more in this blog.
What is the premium option?
Options premium is the amount of money that an options seller gets and an options buyer pays while entering into an options derivative contract. It acts like a sunk cost for this financial agreement which gives the right but not the obligation to buy or sell the underlying asset at a pre-set expiration date and strike price.
What factors affect options premium value?
- Intrinsic contract value
An options contract’s intrinsic value plays a major role in determining the options premium amount. It helps understand the returns you may get by exercising your right. Now, whether you hold the call or put option, you can calculate its value using these formulae:
Intrinsic value of call option = Spot Price – Strike Price
Intrinsic value of put option = Strike Price – Spot Price
While making this calculation, you must remember that an options contract’s intrinsic value can be zero, but it cannot be negative. Moreover, calculating this value will let you determine how much an options contract is in-the-money (ITM) and to what degree it may affect its premium value.
Please note, at-the-money (ATM) and out-of-the-money (OTM) call options do not have any intrinsic value.
- Underlying asset value
In derivatives options, contract value is based on its underlying asset’s price. Now, if the asset value increases, the call option value will appreciate while the put option value will depreciate.
Alternatively, if the underlying asset’s value falls, the call option price will depreciate and the put option price will appreciate.
- Time value
An option contract’s time value denotes how much time is left for that agreement to expire. Usually, options with more time value fetch a higher premium, and it will keep on decreasing as the date of expiration approaches.
You can calculate the time value using the formula:
Time Value of an Options Contract = Premium amount – Intrinsic Value
- Rate of interest
Usually, when the rate of interest rises, traders who have an adequate amount of capital to buy securities will prefer to save their funds in an interest-bearing account. Instead, they will purchase call options for their target assets as they are less expensive than the underlying security itself. This creates a huge demand for call options in the market, thereby raising their premium.
Now, consider a trader who is considering the sale of assets. The alternative for him would be to buy a put and fix his sale price. If the interest rate is high, the trader would consider the immediate sale of securities to invest the amount at a high interest rate. Thus, in an environment with a high interest rate, premiums depreciate.
As you already know, the value of an options contract depends on its underlying asset. Thus, as volatility in the market increases, it will cause a fluctuation in the asset value along with the option premium. Usually, the premium amount tends to rise with volatility. The reason is that this factor enables investors to capitalise on their gains within a short period of time.
- Dividend on the underlying security
This factor is only applicable in cases where the underlying asset is an equity stock. If there are dividend announcements by the issuing company while the options contract is still active, the stock exchanges adjust the options positions.
According to SEBI guidelines, if, on the announcement date, the dividend value is greater than 10% of the option’s spot price, there would be a reduction in the strike price, which is equal to the dividend amount.
However, if the dividend value is less than 10% of the spot price value, no adjustments are made by the exchanges. Thus, rising dividend values will decrease the call option value and increase the put option premium.
What is the formula for calculating option premium?
You can calculate option premium by using the formula:
Option premium = Intrinsic Value + Time Value
Now, when you invest in options, there are multiple shares present in one derivative contract which is called a lot. The number of shares constitutes the lot size. So, to calculate the total premium amount, you can use the formula:
Total Premium Payable = Premium per share X lot size
Apart from using these formulae, you can also use an online call and put option calculator for determining the contract premium amount.
Derivatives contracts are mostly used by traders for speculation and hedging. If you are planning to enter this market segment, it is crucial that you have a clear understanding of how derivatives contracts work and their associated risks.
Frequently Asked Questions
How can I settle an options contract?
You can settle an options contract in three ways – by squaring off your position before contract expiry, exercising the option or allowing it to expire worthless.
What are the different types of options?
There are four different kinds of options : long call, long put, short call and short put. Usually, bullish traders purchase calls and sell puts. Whereas, bearish traders sell calls and buy puts.
Can I lose the premium amount in an options contract?
If you have bought an option and it becomes out-of-The-Money (OTM), it will expire worthless. Under such circumstances, you will lose the option premium paid and the seller earns all of it.
When can investors settle an options contract?
Investors can settle an options contract at any point in time till the expiry date approaches. However, if that is not done, the clearing house will settle the contract by default on expiry.