Option Premium – Definition

Cite this article as:"Option Premium – Definition," in The Business Professor, updated March 31, 2019, last accessed October 25, 2020, https://thebusinessprofessor.com/lesson/option-premium-definition/.


Option Premium Definition

Option Premium is the value that the writer of an option receives from an investor purchasing the option contract.

A Little More on What is Option Premium

An option sets a price (strick 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 ā€œoption premiumā€.

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 ā€œuseful lifeā€

As the exercise date approaches, the time value also comes close to $0. The intrinsic value represents the differences in the security value and the agreementā€™s strike price.

References for Option Premium

Academic Research on Premium Options

Contingent premium options, Kat, H. (1994). Ā The study explains the options of a contingent premium. They are also described as CPOs. A closed-form strategy is used for independent and path dependent contingent premium options. Certain hedging contingent premium options can become problematic when CPOs reach to maturity. The study also discusses a mechanism of how to make certain CPOs for money-back and pay-later options. This is because these are a source of attraction for the investors. Ā 

Executive stock options: evidence that premium and discount awards do matter, Rosser, B., & Canil, J. (2004). This paper addresses the level of ESOs (Executive Stock Options) to evaluate the significance of premium and discounted awards. They are highly important for shareholders returns. Discounted awards generate incentive effects. Exercise limitations reduce exercise rates but they are preferred as the premium award. Generally, a discount offer has many hurdles; however, it does not have vesting restrictions. Shareholders are the most beneficiaries of regular awards that are discounted without any price restrictions. Ā 

An Introduction to Special-Purpose Derivatives: Roll Up Puts, Roll Down Calls, and Contingent Premium Options, Gastineau, G. L. (1994). The Journal of Derivatives, 1(4), 40-43. This paper provides information on special-purpose derivatives and discusses the role of CPO (Contingent Premium Options), roll-up-puts and roll-down calls. It allows an exchange of initial option position regarding adverse price move before its expiry.

Participating Contingent Premium Options, Rajae, A., & Amina, D. (2017). Review of Pacific Basin Financial Markets and Policies, 20(01), 1750003. This review paper is about ā€˜Participating CPOsā€™. The motivation behind the creation of derivatives is considered a hedging risk. However, a significant change has been noticed in this motivation using conventional contracts for speculation. This research proposes a framework concerning Participating CPOs to improve financial activity standards.

Valuation of the Premium Options for Flexible Premium Equity-Indexed Annuities, Essis-Breton, N., & Gaillardetz, P. (2013). This paper explains the EIAs valuation of the premium options that are used for flexible premium equity-indexed annuities. The research shows that EIAs provide a significant number of options to investors.

Optimal exercise prices for executive stock options, Hall, B. J., & Murphy, K. J. (2000). American Economic Review, 90(2), 209-214. This review paper elaborates the optimal exercise prices behind executive stock options. Exercise prices can be set up or down the grant-date of market price. The authors present an operationally beneficial substitute to Black-Scholes (1973) to evaluate ESO (Executive Stock Options) measuring the Incentives Created by options. Ā 

The risk premium of volatility implicit in currency options, Guo, D. (1998, March). Proceedings of the IEEE/IAFE/INFORMS 1998 Conference on (pp. 224-251). IEEE. The findings in this paper are based on a theoretical investigation related to the process of risk-neutral variance. The study shows that there are three primary contributors, Hestonā€™s model, implied parameters in combination with historical moments related to variance risk & their market price and out-of-sample test. Ā Ā 

Liquidity effect in OTC options markets: Premium or discount?, Deuskar, P., Gupta, A., & Subrahmanyam, M. G. (2011). Journal of Financial Markets, 14(1), 127-160. The paper discusses liquidity effects in over-the-counter options concerning markets evaluation of asset prices if it should be considered premium or discount. The writer highlights that illiquid options trade at higher prices compared to liquid options. Such a liquidity discount is considered opposite to bonds or equities. They are according to OTC market structure and comply with its demand-supply forces.

The volatility risk premium embedded in currency options, Low, B. S., & Zhang, S. (2005). Journal of Financial and Quantitative Analysis, 40(4), 803-832. In this paper, the writer examines the volatility risk premium of over-the-counter currency options. The study uses a large database of 4 main currencies, Pound Sterling, European currency Euro, Swiss currency Franc, and Japanese Yen. The results indicate that volatility risk is present with various option maturities. The study also finds the role of jump risk in the currency market.

The trouble with stock options, Hall, B. J., & Murphy, K. J. (2003). Journal of economic perspectives, 17(3), 49-70. This paper highlights various issues of stock options. Such scenario exists because a large number of people are granted with many options. Most of the options are given to second level management that is under top-executive. This does not motivate or attract lower-level workers and executives. The writer presents a substitute model to resolve such issues. Ā Ā 

Liquidity Effects in Interest Rate Options Markets: Premium or Discount?, Deuskar, P., Gupta, A., & Subrahmanyam, M. G. (2008). The authors investigate on we can generalize the liquidity premium in the prices of assets to OTC (Over The Counter) derivative markets or not. With the help of its floor and interest rate cap information, we see that liquid options prefer to deal in higher prices. We cannot generalize the liquidity impact on the prices of assets if we ignore the features of a market.

Effect of premium, copayments, and health status on the choice of health plans, Naessens, J. M., Khan, M., Shah, N. D., Wagie, A., Pautz, R. A., & Campbell, C. R. (2008). Medical Care, 1033-1040. The author comprehensively states the effects of premium and opayments of health status while choosing them for employee health plans. The research shows the results concerned with self-funded medical care if they are changed to costs. However, certain plans in large medical group practices were changed introducing two new options. The first is known as lower premium and the second is higher premium. Ā 

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