What is Option Premium and How is it Calculated?

When you hear the word “premium,” you might think of insurance policies or luxury products. But in the world of trading, especially in the derivatives market, “option premium” has a whole different meaning. If you’ve ever wondered what option premium means, how it’s calculated, and why traders pay it, you’re in the right place. In this article, we’ll break it all down in simple terms that even a high school student can understand.

What Is an Option?

Before we dive into the option premium, let’s first understand what an option is. In trading, an option is a financial contract that gives the buyer the right (but not the obligation) to buy or sell an asset at a specific price before a certain date. The asset can be anything—stocks, indices, commodities, or currencies.

There are two main types of options:

Call Option: The right to buy.
Put Option: The right to sell.

Now, here’s the catch. You don’t get this right for free. You have to pay something upfront, and that payment is called the option premium.

Option Premium Meaning

Option premium is the price you pay to purchase an option contract. Think of it like paying a booking fee. Imagine you want to book a hotel room in Goa for your vacation during the Diwali holidays. You pay a small fee to lock in the room. If you go on the trip, great—you stay there. If you cancel, you lose just the booking fee. Similarly, when you buy an option, the premium is like that non-refundable fee.

The person who receives this premium is the option seller or writer. They take on the risk of fulfilling the contract if you choose to exercise your right.

Why Do Traders Pay Option Premiums?

There are several reasons traders are happy to pay option premiums:

Limited risk: The buyer’s maximum loss is only the premium paid.
Leverage: You control a large quantity of the underlying asset by paying a relatively small premium.
Hedging: Investors use options to protect themselves against market fluctuations.
Speculation: Some traders simply bet on the direction of the market.

Components of Option Premium

Option premium is not just a random number. It’s made up of two main parts:

1. Intrinsic Value

Is the actual profit you’d make if you exercised the option right now.

For call options, intrinsic value = current price of the asset – strike price (if this value is positive).
For put options, intrinsic value = strike price – current price of the asset (again, if this value is positive).

If the result is negative, the intrinsic value is zero.

2. Time Value

This is the extra amount you pay for the possibility that the market might move in your favour before the option expires. The longer the time to expiry, the higher the time value.

Formula:

Option Premium = Intrinsic Value + Time Value

How Is Option Premium Calculated?

There are several models used to calculate the option premium. The most widely used is the Black-Scholes Model, but for simplicity, let’s focus on the practical factors that affect the premium. Here are the five major factors that influence option premium:

Price of the underlying asset: The more favourable the market price is to the strike price, the higher the premium. If a stock is trading much higher than the strike price of a call option, that call option becomes more valuable.
Strike price: The difference between the strike price and the current market price determines how “in-the-money” or “out-of-the-money” an option is. In-the-money options have higher premiums.
Time to expiry: The more time left before the option expires, the greater the chance that the market might move in your favour. That’s why longer-term options usually have higher premiums.
Volatility: Higher volatility means greater price swings. The more volatile a stock is, the higher the chances of profit. So, high volatility leads to higher option premiums.
Interest Rates and Dividends: Higher interest rates can slightly increase call premiums and decrease put premiums. Expected dividends reduce call option premiums, because the stock price may fall after the dividend is paid.

Example of Option Premium Calculation

Let’s say you buy a call option for Reliance Industries with:

Strike Price: ₹2,400
Current Market Price: ₹2,500
Option Premium: ₹120
Time to Expiry: 1 month

Intrinsic Value = ₹2,500 – ₹2,400 = ₹100

Time Value = ₹120 – ₹100 = ₹20

So, you’re paying ₹120 for the option, of which ₹100 is real (intrinsic) value and ₹20 is the time value.

How to Use Option Premium in Trading Strategy

Understanding the option premium is key to choosing the right options and managing your risk.

1. Buying Options

When you expect the market to move significantly in a particular direction, buying options can give you good returns with limited loss.

Buy a call option if you expect the price to rise.
Buy a put option if you expect the price to fall.

Here, the premium is your maximum loss.

2. Selling Options (Writing)

If you believe the market will remain flat or move slightly, you can sell options and collect the premium as income. But remember, this comes with unlimited risk. If the market moves against your expectations, your losses can be huge. That’s why selling options is best left to experienced traders or those who use proper hedging techniques.

Option Premium vs Stock Price

It’s important to note that while a stock can be held forever, options have a limited lifespan. So, option premiums change daily based on the factors we discussed. A stock might not move much, but the premium of its options could fall due to time decay. As the expiry date gets closer, the time value drops—this is known as theta decay.

Where to Find Option Premium in India?

You can find real-time option premiums on trading platforms like:

NSE India website (https://www.nseindia.com)
Stock trading apps like Zerodha Kite, Groww, Upstox, Angel One, etc.

Look for the “Option Chain” of a stock to see the strike prices and their respective premiums.

Tax on Option Premiums in India

Option trading is considered a business activity for tax purposes in India. So, profits or losses from trading options fall under business income.

Option buyer: If you make profits from exercising or selling options, it’s taxable as business income.
Option seller: The premium you collect is your income, and losses are also considered.

You can deduct expenses like brokerage, internet charges, etc., and file your taxes accordingly under ITR-3.

Conclusion

The option premium might look like just a number at first glance, but it holds a lot of information about market expectations, risk, and time. As an investor or trader, understanding this concept can help you make better decisions in the derivatives market.

Whether you’re hedging your portfolio, speculating on price movements, or trying to earn income through writing options, knowing how premiums work is crucial. So the next time you see a premium of ₹150 on an option, you’ll know exactly what goes into that figure—and how it affects your trade.