Premium is not a brokerage.

The premium amount to be paid, must not be misunderstood as the brokerage for the options contract. Brokerage is something everyone has to pay the broker depending on the transactions. Premium is the amount paid to the option writer by the buyer.

Only the buyer pays a premium

We have seen in the earlier chapter on options that it is the buyer of the option who gets the right to buy or sell the shares. The buyer of the option contract will sell the shares only if there is a gain or allow it to lapse. The option seller or writer does not have a choice and is obliged to perform. The seller’s position is a risky one. As compensation for the risk, the buyer pays an amount called a premium to the seller. It is always the buyer who pays the premium.

The option premium has two values.

One is the intrinsic value, which is the strike price minus the spot price. The other one is the extrinsic value, which is also known as the time value.

Only those options which are in-the-money have an intrinsic value. A value above the intrinsic value of an option is the extrinsic value.

Let us assume that the shares of Infosys are trading at Rs.1000, and the premium for the call option of strike price 950 is Rs.70. Here, the intrinsic value of the option is Rs.50 (spot price minus the strike price), and the extrinsic value, also called the time value, will be Rs.20.

Let us now look at the time value or extrinsic value. The option gets a time value because of the probability of the option moving further in-the-money and becoming more profitable before expiry.

When the time left for expiry is more, the possibility of making a profit is high. When the time to expiry is less, then the chance for profit is less.

Just like the possibility of the option moving further in-the-money when the time to expiry is more, there is a possibility of the options becoming less profitable when the time to expiry reduces.

Two factors determine the time value of the options. The possibility of the stock price going up or down, and time left.

To benefit from the potential price increase, someone who has bought a call option, the time value is the extra price he is willing to pay over the intrinsic value. For the option writer, it is the charge he takes for taking the risk.

Before we end, here are some more tips –

• The premium for the options is paid to the writer in advance.

• The premium for the option has to be paid to the writer by the buyer.

• Premium has to be paid whether the option is exercised or not.

• Brokerage and premium are two different things.

• The time value of the option decreases as the date of expiry draws near.

• On expiry, the time value will be zero.

• There is no intrinsic value for out-of-the-money options, and so time value will be equal to option price.

• High time value is the result of the high volatility of the stock.

• Two call options having different strike prices, but the same expiry will have two different time values. It will depend on how close each option is to to-the-money.

• Premium is also affected by the declaration of dividend on the stock.

• Interest rates also play a role in deciding the premium.