Option Premium - Explained
What is an Option Premium?
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Table of ContentsWhat is an Option Premium?How Does an Option Premium Work?
What is an Option Premium?
Option Premium is the value that the writer of an option receives from an investor purchasing the option contract.
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How Does an Option Premium Work?
An option sets a price (strike price) at which the option holder can either purchase or sell and referenced security. The ability to force this transaction has value, known as the option premium. The option will have a specified date for execution or exercise. The option holder will watch the strike price and compare it to the actual price of the security, as that date approaches. If exercising the option produces value, it is known as in-the money. Producing value means the options holder has the ability to sell the security at a higher price than market value, or the ability to purchase the security at a lower than market value. If the option produces no value, it is out of the money. There are certain factors that affect the option price. It begins with the price of the underlying security. Changes in the price of the underlying security will change the value of the option. With a security and call option (the ability to purchase the security at a given price), when the price of the underlying security rise - the option is more valuable. Conversely, the price of a put option (the ability to force another to purchase the underlying security from you) declines when the price of the underlying security rises. Another element is the time value of the money used to purchase the option. The time before expiry (also known as the useful lifeAs the exercise date approaches, the time value also comes close to $0. The intrinsic value represents the differences in the security value and the agreements strike price.