Option premium
What is Option premium?
Option premium is the price paid by the option buyer and received by the seller when the contract is traded, quoted according to its market convention.
Premium is a market price for a contingent payoff, not a standardized measure of expensiveness. A defensible comparison considers implied volatility surface, expected distribution, realized path, liquidity, funding, and hedge cost. Buyers exchange cash today for optionality; writers exchange optionality for cash today. Neither side earns a return simply because the initial premium changed hands.
What premium contains
Premium can be separated conceptually into intrinsic value and time value. Time value reflects remaining life, volatility, rates, dividends, borrow, events, and supply and demand. It generally declines toward expiration, but not at a constant rate. Quoted premium must be multiplied by the contract multiplier and quantity to determine actual cash consideration.
Example
A call is quoted at $2.50 with a 100-share multiplier, so one contract costs $250 before fees. If the option is in the money by $1, approximately $1.50 is time value. A $2.50 quote is not 2.5% and does not describe maximum loss for the writer, whose obligation can be much larger.
Premium versus profit
For a buyer, paying premium establishes cost but break-even at expiration also depends on strike. For a seller, receiving premium is not immediate economic profit because an offsetting liability remains. Mark-to-market gains and losses occur before expiry, and assignment or closing trades can change realized cash. Accounting and tax timing can differ from economic exposure.
Comparing premiums
Raw premiums across strikes, maturities, underlyings, and multipliers are not comparable. Implied volatility normalizes price through a model but carries assumptions and should be viewed across the surface. Bid-ask spread, open interest, market depth, and event timing matter. A small premium can reflect a low-probability payoff with severe leverage rather than a bargain.
Risks and practical checklist
Confirm quote convention, multiplier, currency, bid, ask, settlement, and fees. Decompose intrinsic and time value, review implied volatility and scenarios, and distinguish premium paid from margin posted. Sellers should stress losses beyond collected premium and buyers should assume full premium can be lost. Avoid annualizing short-term premium as income without incorporating tail loss and repurchase cost.
Sources and further reading
- Investor Bulletin: An Introduction to Options, Investor.gov, U.S. Securities and Exchange Commission