What is Option Premium & How is it Calculated?

Trading in the stock market is not always limited to buying and selling shares. Many traders and investors prefer to use other financial products to either protect their investments or to make profits from price movements. One of the most popular financial products in this category is the options contract. 

Whenever you enter into an options contract, you have to deal with something called an option premium.

In this blog, we will explain what an option premium is, how it is calculated, what factors affect it, and how it is taxed in India in very simple words.

Understanding the Meaning of Option Premium

If you are wondering what exactly an option premium means in the simplest words, it can be described as the cost a buyer pays to gain the rights stated in the option contract. This cost is fixed when the trade is made. The buyer pays it upfront, and the seller accepts it as income in exchange for taking on a certain risk.

The importance of this premium is that it takes the form of a maximum loss to the buyer. In case the market is trading contrary to the direction, the prospective buyer is free to merely permit the option to lapse, holding minimal risk; that is, the payment made as a premium. 

On the part of the seller, the premium is compensation to them in case they risk consummating the contract in the chance that the buyer may exercise the right.

Why Does the Option Premium Exist?

In order to grasp the existence of the option premium, we must know that there is some risk associated with every trade. The option seller also takes an agreement whereby he or she will acquire or sell the underlying asset at a specified price at any future period at the discretion of the buyer. This is risky since the market price can sharply move in a manner that makes the seller suffer losses.

Due to this risk, the buyer pays a premium to the seller. To the buyer, such an amount of payment is justified given the flexibility and control of the buyer, which is not subjected to compulsion to purchase or to sell even when the market forces are unfavourable.

Read Also: What Is an Option Contract?

The Main Parts of an Option Premium

An option premium is made up of two main parts. Knowing them will help you understand how the price is calculated:

1. Intrinsic Value

This is the profit you would make if you used the option right now. For a call option, it is the current market price minus the strike price. If the result is negative, it becomes zero. For a put option, it is the strike price minus the current market price. Again, if the result is negative, it is zero.

2. Time Value

This is the extra amount the buyer is willing to pay because there is still time left before expiry. More time means more chances for the price to move in a profitable direction. As time lapses, the time value goes down and on expiry day, it becomes zero. The option seller benefits from time decay (Theta) when the stock shows little or no movement as time passes.

How to Calculate Option Premium

When you combine these two parts, you get the formula for the option premium. It is simply the sum of the intrinsic value and the time value. Some advanced pricing models like Black–Scholes–Merton (BSM) model also consider market volatility, risk-free rate as a separate part, but for beginners, focusing on intrinsic and time value is enough to understand the basics.

Example of Option Premium for a Call Option

It is easier to understand this concept with an example. Imagine the current market price of a company’s stock is ₹1,200. You hold a call option with a strike price of ₹1,150, and the time value of this option is ₹30. The intrinsic value will be ₹1,200 minus ₹1,150, which is ₹50. Adding the time value of ₹30 gives a total premium of ₹80 per share. If your contract size is 100 shares, then you will pay ₹8,000 in total.

Example of Option Premium for a Put Option

Now let us take the example of a put option. Suppose the current market price is ₹900, the strike price is ₹950, and the time value is ₹20. The intrinsic value is ₹950 minus ₹900, which equals ₹50. Adding the time value of ₹20 gives a total premium of ₹70 per share. If your contract size is 200 shares, then the total amount you pay will be ₹14,000.

What Affects Option Premium in the Market

The option premium you see in the market is not fixed forever. It changes every day depending on different factors.

• Current market price of the asset – If the price moves in a way that benefits the buyer, the premium usually goes up.
• Strike price – The nearer the strike price is to the current market price, the more valuable the option may be.
• Time left before expiry – More time gives more chances for price changes, so premiums are usually higher.
• Volatility – If prices move a lot in a short time, the option becomes more valuable because of the higher chance of big profits.
• Interest rates – Higher interest rates can slightly affect premiums.
• Expected dividends – Upcoming dividends can change the value of options, especially for stocks.

Read Also: Call and Put Options: Meaning, Types, Difference & Examples

How Option Premium Works in Real Trading

In real trading, the buyer pays the premium on the day the trade is made. This payment is final and is not returned, even if the option is not exercised. For the buyer, this is the maximum amount an investor can lose. If the market moves against them, they can simply let the option expire without taking further losses.

For the seller, the premium is received at the start and is theirs to keep and it is maximum profit for the seller, but the risk is much higher. If the market moves sharply against them, they may face losses far greater than the premium they received.

How Option Premium is Taxed in India

In India, an option premium is treated in tax differently depending on your trading activity (buyer or seller) and your trading activity.

To a buyer, the amount of premium paid is regarded as a cost of buying the option. This cost is offset against which the profit or loss is computed when the option is sold or exercised. In the case that the option lapses without exercise, then the premium is treated as a loss.

In the case of a seller, the premium obtained is treated as business income in the event of trading of options in established stock exchanges and it is taxed based on your income tax slab. The losses accrued in the trade of options are eligible to be offset with the other income that the business earns; they can also be carried through for eight years when you present your tax returns on time.

Why Knowing Option Premium Matters

Knowing about option premiums is not meant only for advanced traders. Knowing how it works is useful even to the novice. Your premium will inform you of how much you will really pay on the trade, and the lead you will be able to calculate the upper limit loss you can incur as a buyer. It also enables you to put in comparison various options so as to identify those that can be adopted as more appropriate concerning your goals.

In the case of sellers, it becomes easier to know the likely profits and risks that may arise by knowing the determination of the premium. Selling options may cause you to miss big losses, and hence, you should not put yourself in a compromised position by not knowing what you are getting yourself into when buying a premium.

Risks Involved with Option Premium

Trading options is a risky business. On the side of buyers, one can only risk the premium price, losing which is an opportunity as well, when the market does not shift in the planned way. The risk is more dramatic in the case of sellers, as they might end up purchasing or selling an asset at unfavourable prices, which will incur great losses.

Read Also: Options Trading Strategies

Conclusion

The heart of any option trade is the option premium. It shows the current profitability of the contract as well as the prospects of profits by the time of expiry. Knowing how it is calculated, what affects it, and how it is treated as far as taxes are concerned, you will be able to make better choices in the options market.

When you purchase options to hedge, to speculate, or get income, it is good to know the precise amount of money that you pay or are being paid as a premium so that your risk management is made easier. Ultimately, options trading does not only entail forecasting of prices, but also encompasses the calculation of costs and benefits.

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