Chapter 7 | 2 min read

Option Premium Explained

Introduction

The premium is the price of an option. It changes every second during market hours. To trade options well, you must understand what the premium is made of and why it rises or falls.

Premium = Intrinsic Value + Time Value

1. Intrinsic Value

This is the real value the option would have if it expired right now.

  • Call intrinsic value = Current price - Strike (if positive, otherwise zero)
  • Put intrinsic value = Strike - Current price (if positive, otherwise zero)

2. Time Value

This is the extra amount buyers pay for the chance that the option will become more valuable before expiry. Time value becomes zero at expiry.

Example (Illustrative)

Nifty is at 24,100. The 24,000 call is trading at Rs 190.

  • Intrinsic value = 24,100 - 24,000 = 100.
  • Time value = 190 - 100 = 90.

The 24,200 call is trading at Rs 70.

  • Intrinsic value = 0 (it is OTM).
  • Time value = 70. The whole premium is time value.

What Makes the Premium Change?

  • Price of the underlying: calls rise when the price rises; puts rise when the price falls.
  • Time to expiry: more time means more time value. As expiry comes closer, time value melts away.
  • Volatility: when the market expects big moves, such as before results, the budget or elections, premiums become expensive. When things calm down, premiums fall.
  • Interest rates and dividends: smaller effects, mostly important for longer-dated options.

Time Decay Example (Illustrative)

An ATM Nifty call is worth Rs 150 with 14 days to expiry. If Nifty does not move at all:

  • After 7 days: about Rs 105
  • After 12 days: about Rs 50
  • At expiry: Rs 0 (if still exactly ATM)

Time decay speeds up as expiry approaches. This hurts option buyers and helps option sellers.

Volatility Example (IV Crush)

Before a company's results, its ATM call trades at Rs 40 because traders expect a big move. After results, the stock rises only 1%, but the call falls to Rs 25 because the uncertainty is gone. This drop in premium due to lower volatility is called IV crush.

Watch Premiums on GoPocket

On the GoPocket app, note the premium of an ATM Nifty call on Monday and track it every day until expiry. You will clearly see time decay in action.

Key Takeaways

  • Premium = intrinsic value + time value.
  • Time value falls every day and faster near expiry.
  • High volatility makes premiums expensive.

Disclaimer: Illustrative figures only.