Learn the stock market › Options › Lesson 5 of 9
What is an option premium?
How to read a premium
The premium is quoted per share. A contract generally covers 100 shares, so a premium of $5 costs $500. At a premium of $4.98 the contract's price is a hundred times that.
Two parts
Intrinsic value. If the stock is at $100 and a call's strike is $90, you can buy $10 below the price. Those $10 are the intrinsic value. If the strike is above the price it is zero, never negative.
Time value. The rest of the premium. As long as there is time left the stock can still move, and that costs money. Time value is gone at expiry.
Here are calls with three months left on a stock at $100. The prices are an example, worked out with a model and a volatility of 25%.
| Strike | Intrinsic value | Time value | Premium |
|---|---|---|---|
| $80 | $20.00 | $0.17 | $20.17 |
| $90 | $10.00 | $1.32 | $11.32 |
| $100 | $0.00 | $4.98 | $4.98 |
| $110 | $0.00 | $1.68 | $1.68 |
| $120 | $0.00 | $0.44 | $0.44 |
With a $90 strike the premium is $11.32, of which $1.32 is time value. Time value is largest when the strike is close to the price, because that is where the outcome is least clear.
An option with a $110 strike costs $1.68 and has no intrinsic value. It is cheap in dollars, but the whole premium is time value: if the stock has not risen enough by expiry, all of it is gone.
How time and volatility affect the premium is something you can work out yourself in a later lesson.
Test yourself
The stock is at $100. A call with a $95 strike costs $8. How large is the time value?