An option premium may refer to two different types of investment scenarios. One common usage of the term has to do with the amount of income that an investor receives when writing an option contract. In addition, an option premium may also mean the current price associated with a given options contract that has not yet been settled. As it relates to shares of stock that may be involved with an options contract, the premium is normally presented as a specific price per share.
When used to identify the income that an investor generates from selling or writing an options contract, that income is often associated with an attempt to qualify the anticipated outcome of writing a put or a call. Often, employing the premium in this manner is not just an end to itself, but part of a more comprehensive investment approach that is likely to have some impact on the investor’s entire portfolio. This is particularly true if the investor plans on using hedging on a significant portion of the assets currently held in the portfolio.
In situations where the option premium refers to the current price per share associated with an options contract, the premium represents the price that must be paid if a deal involving those shares of stock is to be settled immediately. Over time, the option premium is subject to change, usually decreasing as the expiration date on the option approaches. This means that the time value of the premium will change, but that change has no real effect on the intrinsic value of the shares themselves. Instead, the intrinsic value as it relates to the options contract and the intended actions of the investor would be identified by determining the current difference that exists between the strike price named in the options contract, and the price of the underlying security.
With both common uses of the term, an option premium helps an investor to organize a strategy and determine if that strategy is likely to produce the desired results, whether implemented immediately or structured to trigger a put or a call at a later date. By understanding the current price associated with an options contract, and accurately projecting the movement of that contract, the investor can determine exactly when to initiate a transaction and achieve the most benefit. When the strategy is carefully planned and executed, the end result is a positive impact on the portfolio and the enhancement of the investor’s overall financial worth.