Core Concepts
Understanding Option Premium
Learn what option premium is, how option prices are quoted, what affects premium, and why premium matters when buying or selling options.
What Is Option Premium?
Option premium is the price of an option contract. It is the amount the option buyer pays and the amount the option seller receives when the contract is opened.
Premium changes throughout the trading day as market conditions, the underlying price, time to expiration, volatility, and other pricing factors change.
Simple definition
Premium is the market price paid for an option contract by the buyer and received by the seller.
Option Premium Is Quoted Per Share
Stock and ETF options are generally quoted on a per-share basis, while one standard contract normally represents 100 shares.
That means the premium shown in an option chain must normally be multiplied by 100 to determine the dollar value of one contract.
Quoted Premium
$0.50
Shares Per Contract
100
Contract Value
$50
$0.50 × 100 shares = $50
This simplified example does not include commissions, contract fees, or other transaction costs.
Premium From the Buyer's Perspective
When you buy an option, the premium is the amount you pay to obtain the rights provided by that contract.
Example
If you buy one option for $1.25, the contract generally costs approximately:
$1.25 × 100 = $125
For a buyer, the underlying must move enough—or other option pricing factors must change enough—for the option's value to overcome the premium paid if the position is to become profitable.
Premium From the Seller's Perspective
When you sell an option, you receive premium in exchange for accepting the obligations of the contract.
Example
If you sell one option for $0.40, you generally receive:
$0.40 × 100 = $40
Receiving $40 does not mean the trade has already produced a $40 profit. The short option remains an open position and its value can move higher or lower until the position is closed, expires, or is assigned.
What Determines Option Premium?
Option prices are affected by several variables working together. Premium is not determined by one factor alone.
Underlying Price
Changes in the stock or ETF price can change the value of calls and puts.
Strike Price
The relationship between the strike and the current underlying price affects the option's value.
Time to Expiration
More remaining time generally gives the underlying more opportunity to move, which can contribute to option value.
Implied Volatility
Higher expected volatility generally increases option premiums because larger future price movements are being priced into the contract.
Interest Rates
Interest rates are one of the inputs that can affect option pricing.
Expected Dividends
Expected dividends can affect the pricing relationship between calls and puts on dividend-paying stocks.
Intrinsic Value and Extrinsic Value
Option premium can be understood as a combination of intrinsic value and extrinsic value.
Intrinsic Value
Intrinsic value is the amount an option is currently in the money.
Extrinsic Value
Extrinsic value is the portion of premium beyond intrinsic value. It reflects factors such as remaining time and expected volatility.
Option Premium = Intrinsic Value + Extrinsic Value
Example: Intrinsic and Extrinsic Value
Suppose a stock is trading at $52 and a call with a $50 strike is trading for $3.00.
Premium
$3.00
Intrinsic Value
$2.00
Extrinsic Value
$1.00
The call is $2 in the money, giving it $2 of intrinsic value. The remaining $1 of its $3 premium is extrinsic value.
Premium and Time Decay
The extrinsic portion of an option's premium generally decreases as expiration approaches, assuming other pricing factors remain unchanged.
This is the time-decay effect discussed in the Understanding Theta lesson.
At expiration
There is no remaining time value. An option that expires out of the money has no intrinsic value and expires worthless.
Why Higher Premium Is Not Automatically Better
A larger premium can look attractive to an option seller, but there is usually a reason the market is pricing the contract higher.
Higher premium may be associated with a strike closer to the current stock price, more time to expiration, greater implied volatility, or another factor that changes the trade's risk.
Premium should be evaluated together with risk.
The goal is not simply to find the option paying the most money. Strike, Delta, DTE, return on capital, the underlying, and the amount of risk being accepted all matter.
Premium in a Cash-Secured Put
Suppose a stock is trading at $50 and you sell a $45 cash-secured put for $0.60.
Strike
$45
Premium
$60
Breakeven
$44.40
The $60 premium is the maximum option premium profit from the short put if it expires worthless and no adjustment or closing transaction changes the result.
If assignment occurs, the $0.60 premium lowers the simplified premium-adjusted share cost from $45 to $44.40 per share.
Premium in a Covered Call
If you own 100 shares and sell a covered call for $0.75, you receive approximately $75 in premium.
In exchange for that premium, you accept the obligation to sell your shares at the call's strike price if assignment occurs.
The trade-off
The premium provides income, but the covered call can limit your upside because your shares may be called away at the strike even if the stock rises substantially higher.
Premium and the OptionEdge Approach
Premium matters to an income-focused options strategy, but OptionEdge does not treat premium as the only reason to enter a trade.
Risk First
Understand the obligation and capital at risk before focusing on the income.
Evaluate the Setup
Consider Delta, DTE, strike distance, premium, and the underlying together.
Don't Chase Premium
More premium can come with more risk. Income should be evaluated relative to the risk being accepted.
Premium Received Is Not Guaranteed Profit
This distinction is especially important for option sellers. Premium may enter your account when the trade opens, but you still have an open liability.
Example
You sell an option for $0.50 and receive $50. If the option later rises to $1.20 and you choose to buy it back, closing the contract would cost approximately $120.
$50 received − $120 paid = -$70
This simplified example excludes fees and taxes.
Common Premium Mistakes
Forgetting that option quotes are generally shown per share rather than per contract.
Treating premium received as guaranteed profit before the trade is finished.
Choosing a trade only because it offers a large premium.
Ignoring the reason a contract may be priced higher than another contract.
Ignoring Delta, DTE, strike selection, volatility, and the underlying.
Assuming a small premium means there is no meaningful risk.
Key Takeaways
Premium is the market price of an option contract.
Option premium is generally quoted per share, while one standard contract normally represents 100 shares.
The buyer pays premium and the seller receives premium.
Premium can contain intrinsic value and extrinsic value.
Underlying price, strike, time, volatility, rates, and expected dividends can affect option pricing.
Premium received by an option seller is not the same as guaranteed profit.
Higher premium is not automatically a better trade because risk and reward must be considered together.