Updated: Apr 8, 2021
Welcome to yet another article regarding the Options trading strategies. In the previous article, we had discussed the option chain analysis in detail. Now, we will discuss the option premium.
Most Investors love options trading because they improve many market strategies. Just think a stock is going to up? If you're correct, buying a call option gives you the right to buy shares later at a discount price to the market value. That means big profits if the stock goes up. Want to lower your risk if your stock unexpectedly goes down? With a put option, you can sell the share later at a present price and limit your losses.
Options can open the door to big profits or protect against possible losses. And, unlike buying or short-selling shares, you can get a significant position with a little bit of upfront capital. Whether you’re buying or selling these options contracts, knowing what goes into an option’s strike price, or premium, is beneficial to long-term success. The more you understand about the option premium, the easier it will be to find out a good deal.
First of all, let's recap the intrinsic value and the time value. The intrinsic value of an option can be explained as the extent to which the option is in-the-money (ITM). What do you know about the ITM options?
An ITM option is one where the right indirect in the option is valuable only because the price is favourable. To know the concept of intrinsic value, one also needs to know the concept of the time value of options trading. It is the sum of the time value and the intrinsic value that shown the market price of the option.
Time value, as the name tells us itself, is the price you pay for the assumption that the option price will move further in your favour. For example, ATM options and OTM options do not have any intrinsic value since there is no price head for the option in both of the cases. Hence, the whole premium of the option replicates the time value only. If all that sounds a bit confusing, then let us break up this task further into call options and put options and find out the intrinsic value of an option in granular detail.
Call Option’s Intrinsic value = Underlying Stock's spot Price - Call Strike Price Time Value = Call Premium - Intrinsic Value
Put Option’s Intrinsic value = Call Strike Price - Underlying Stock's spot Price Time Value = Put Premium - Intrinsic Value
The option premium is regularly changing. It depends on the price of the stock’s underlying asset and the amount of time left in the option contract. The more a contract is in the money, the more the premium rises. In opposite, if the option loses its intrinsic value or goes further out of the money, the premium will go down.
The time left in the options contract also affects the premium. For example, the premium will go down as the contract gets closer to the expiration date. However, the pace of the decline can vary significantly. This time decay is a major factor in the time value.
You’re not going to pay a large sum of money for a blue chip's call option or put an option in the 30-days before the expiration date. It works this way because the chances for a large-scale price movement are low in a short period. Accordingly, its time value will go down well ahead of the expiration date.
In general terms, the option premium is higher for the underlying assets with higher price volatility in the recent year. Option premiums for volatile securities, like blue chips stocks, tend to decrease more slowly. With these analyses, odds for an out-of-the-money option to get to the strike price are higher. Therefore, the option puts its time value longer. Due to these changes, and options traders should measure the stock's implied volatility before placing an order.
The option premium is that the risk-neutral premium that at that particular point whatever the premium is showing that doesn't have any kind of risk. So, if you go down the premium for the put options started increasing and then you can see also the option chain.
Now, let’s know about another dynamic to options premium, specifically relevant in more volatile markets, is option skew. The concept of option skew is somewhat tough, but the most important idea behind it is that options with different strike prices and expiration dates trade at different implied volatilities. The amount of volatility is constant. Preferably, levels of higher volatility are skewed toward taking place more often at certain strike prices or expiration dates.
Every option has a related volatility risk, and volatility risk profiles can vary significantly between options. Traders sometimes maintain the risk of volatility by hedging one option with another.
Now, options premium is affected deeply with implied volatility. Implied volatility is used to measure how volatile a stock’s price may be in the future. High implied volatility means that the market forecast that the stock will have large price swings in either direction. Low implied volatility indicates that the market predicts that the stock will not swing in either direction. Higher implied volatility shows a higher premium price. Whereas lower implied volatility shows a lower premium price.
Understanding how these three factors affect option premiums will make ready investors differentiate between reasonable and unreasonable option premiums. This knowledge will increase investor’s chances of getting a big profit on investment from trading options. I hope you would have understood something new in this article related to the option trading strategies for the beginner.