An option premium is the value of an option contract. I wish that were the end of it, but understanding a premium is critical to understanding options. At its purest form premium only refers to that amount that rises above the innate value of something. Think about collectible pennies. The face value of a penny no matter how rare is 1 cent, but the penny might be worth way more. Assume it is worth $100. The premium you pay for that penny is $99.99.
Previous readers will know that I belabor the value of options nonstop. The main reason is that if I say it six ways, then different people will understand it based on who they are. Do you know how long it took me to wrap my head around it? Far longer than I am proud of considering I was making a concerted effort to learn. For people with lives and families all hope might as well be lost. Hearing it multiple ways is the best way to learn, otherwise you might end up stuck spinning your wheels.
What determines an option premium? A mix of volatility and time value. Remember an option is a right. And the writer of an option is giving up control of their actions for a specific amount of time for a payment. You can always sell the contract and remove yourself of the obligation, but this might cost the writer more or less depending on how the option has moved. The point is that the premium depends on a fancy calculation of how likely action will be required, as opposed to expiry requiring no action, and how long the window for the action remains open.
You can look up the implied volatility of a stock. Don’t be crazy and try to calculate it yourself. There is simply no need. On the writing side you want a lower implied volatility, while still having it high enough to get a good premium on the contracts. You can make up for lack of volatility by going for a longer time. You could write a contract 3 months out, and even with near dead volatility you would get a nice payment. For the person who likes buying and selling options you want to buy when volatility is low, then it goes nuts and volatility goes through the roof.
I think that is enough about premiums. I want to do a more theoretical post about the nature of premiums and the various roles it plays in trading options, but that is complicated and in-depth. I’d rather not overwhelm you with too much technical detail.
Remember, the premium of an option is a combination of its volatility and time. If you are writing an option you want a high premium. If you are trading them, then it just depends. If you are just long options then you want a low premium turning into a high premium as you own the contract.
I am not sure what the next part of this series will be, but it’ll be posted in the same place.
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