Premium
An option premium is the price a buyer pays a seller to acquire the option contract. It is the single most important variable for an options trader because it determines profitability, leverage, and risk. Premium consists of two components — intrinsic value and time value — and is influenced by several pricing factors including the spot price, time to expiry, volatility, interest rates, and dividends.
Key takeaways:
- Premium = Intrinsic Value + Time Value.
- Intrinsic Value is positive only for ITM options.
- Time Value decays as expiry approaches (Theta).
- Implied Volatility (IV) is the biggest swing factor for premiums.
- Premium is quoted per share/unit; total cost = premium × lot size.
The two components of premium
- Intrinsic Value: For a call, max(spot − strike, 0). For a put, max(strike − spot, 0). Only ITM options have intrinsic value.
- Time Value: Premium minus intrinsic value. Represents the “optionality” of remaining time. Always positive (or zero) and decreases as expiry nears.
What drives premium pricing
| Factor | Effect on call premium | Effect on put premium |
|---|---|---|
| Spot price ↑ | ↑ | ↓ |
| Strike price ↑ | ↓ | ↑ |
| Time to expiry ↑ | ↑ | ↑ |
| Implied volatility ↑ | ↑ | ↑ |
| Interest rates ↑ | ↑ | ↓ |
| Dividends ↑ | ↓ | ↑ |
Time decay (Theta)
Time value erodes faster as expiry approaches. The decay is non-linear: an ATM weekly option loses a small portion of premium daily until the last 2–3 days, when decay accelerates dramatically. Selling options near expiry is a popular strategy to harvest this “Theta”.
Implied volatility
IV reflects the market’s expectation of future volatility. Rising IV pumps up premiums; falling IV crushes them. Major events (earnings, RBI policy, US Fed) often see IV spike before and crush after — even when the underlying barely moves. Trade with awareness of IV regime to avoid surprises.
Practical example
Nifty spot 22,000. 22,000 call (ATM, weekly expiry): premium ₹120. 22,100 call: ₹70. 21,900 call: ₹170 (intrinsic ₹100 + time value ₹70). The further the strike is OTM, the smaller the premium but the higher the percentage leverage.
How to read premiums smartly
- Compare premiums across strikes to gauge expected moves.
- Check IV percentile to know if options are cheap or expensive historically.
- Use option chain analytics to find unusual premium spikes (often signal large block orders).
- Always compute total cost (premium × lot) before placing a trade.
Frequently asked questions
Is the premium the same as the strike price?
No. Premium is the cost; strike is the contractual transaction price.
How is premium settled?
Premium is paid upfront by the buyer when the trade is executed; the seller receives it immediately.
Why do premiums shrink overnight even without a move?
Time decay (Theta) reduces premium daily. Implied volatility changes can also reduce premium.
Are premiums refundable?
No. Once paid, the premium is non-refundable. Closing a position at a higher premium realises a profit; closing at a lower premium realises a loss.
