1. Call Option Premium
A call option is the right to purchase the underlying asset at the strike price before or by the expiration date. This right is paid for through the call premium.
Buyer of a Call Option: Pays the premium and is granted the right to purchase the underlying asset at the stipulated strike price.
Call Option Seller (Writer): Receives the premium for accepting an obligation to sell the underlying asset at the strike price if the option buyer exercises his or her option.
How is Call Premium Determined?
The call option premium depends on a number of parameters:.
Example: If the underlying stock is trading at ₹150 and the strike price of the call option is ₹130, then the intrinsic value of the call option is ₹20.
Time Value: The longer the time remaining until expiration, the more time the option has to become profitable, which increases the time value. This is why options with more time until expiration tend to have higher premiums.
The more time to expiration, the higher volatility, and the more out of the money the current price of the underlying is will affect the value of time.
Implied Volatility: Generally speaking, a higher volatility of the underlying will have higher option premiums since there is a better chance the option may end up in-the-money.
Example of Call Premium:
A call on a stock with a strike price of ₹100 has a premium of ₹5.
If the stock price reaches ₹110 at expiry, then the option would have an intrinsic value of ₹10 (₹110 – ₹100), and the buyer can exercise the option to buy at ₹100.
If the stock price does not rise above ₹100 at expiry, the option will be worthless at expiry, and the buyer will be left with losing the premium of ₹5.
2. Put Option Premium
The holder of a put option is given the right to sell the underlying asset on or before the expiration date at a predetermined strike price. The premium of the put is what the buyer pays to purchase this right.
Buyer of the Put Option: Paid the premium and had a right to sell the underlying at the strike price.
Put Option Seller (Writer): He shall get the premium for undertaking the obligation of buying the underlying asset at the strike price in case the buyer exercises the option.
How is Put Premium Determined?
The put option premium is also determined by several factors:
Intrinsic Value: The amount of difference between the strike price and the current price of the underlying asset. An option is said to possess intrinsic value if the strike price of the option is more than the current price of the asset.
For example, consider the case in which the underlying stock price is at ₹80, and the strike price of a put option is ₹100. Then, the intrinsic value of a put option will be ₹20.
Time Value: The more time that remains until expiration, the more chances the underlying will move in favour of the put holder. Generally speaking, the longer the expiry date is, the greater premium one pays.
Implied Volatility: Puts, like calls, are higher in premium where implied volatility is high. It increases the chances the price will change in a manner favourable to making an exercise worthwhile.
Example of Put Premium:
A put option on a stock with a strike price of ₹100 may have a premium of ₹4.
If the stock price falls to ₹90 before expiration, the option has intrinsic value of ₹10 (₹100 – ₹90), and the holder can exercise the option to sell at ₹100.
If the stock price stays above ₹100, the option will expire worthless, and the buyer loses the ₹4 premium.
Why do investors use call and put premiums?
Hedging: An investor buys a call or a put option to mitigate risks that could arise from adverse price movement in the underlying asset. For example, if you are an owner of a stock and are concerned it is going to depreciate in value, you would probably buy a put option for hedging.
Speculation: Options form another route to which a trader resorts in speculating the trend of the market. By purchasing call options, they are likely to gain if they can predict the price of an asset increase. The purchase of put options is equally rewarding when one expects the price for a declining trend.
Income Generation: Investors can also sell options to generate income. The seller of a call option or put option receives the premium in advance. This is generally used in a strategy known as writing options, in which the seller hopes that the option will expire worthless-meaning the underlying asset doesn’t hit the strike price-so they can retain the premium as profit.
Conclusion:
Essentially, the call premium and put premium both are costs to buy the options that reflect the time value of the option-currently, the intrinsic value-its value now as well as the time-value the chance it may become worth more before it expires. A player in options needs the knowledge of these premiums-the cost of entry to their trade, as well as the gain or loss.