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What Is A Premium?

Filed Under Trading Articles 

Premium is the total amount of money (price) you pay for an option. So, if the Microsoft (MSFT) May 65 calls cost you $1.50 then the $1.50 is the amount of the premium of the option.

The total price of an option (premium) consists of two components. Those two components are intrinsic value and extrinsic value.

Intrinsic value, also called parity, is the amount by which an option is in the money. In the case of a call, the intrinsic value is equal to the present stock price minus the strike price. In the case of a put, the intrinsic value is equal to the strike price minus the present stock price. Only in-the-money options have intrinsic value. Out-of-the-money options have no intrinsic value.

For example, with MSFT trading at $65.00, the MSFT January 60 calls will have $5.00 of intrinsic value. If the MSFT January 60 calls were trading at $5.70, then $5.00 of that premium would be intrinsic value.

At the same time, the MSFT January 70 put will also have $5.00 of intrinsic value. So, if the MSFT January 70 puts were trading for $5.70, then $5.00 of that premium would be intrinsic value.

Extrinsic value is defined as the price of an option less its intrinsic value. In the case of out-of-the-money options, the option’s entire price consists only of extrinsic value. Extrinsic value is made up of several components, with the largest being volatility.

In the examples above, if the MSFT January 60 calls were trading at $5.70 and $5.00 of that was intrinsic value, then the remainder ($.70) is extrinsic value. The same also holds true for the January 70 puts. If they were trading at $5.70 and $5.00 of that was intrinsic value, then the rest ($.70) is extrinsic value.

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