Option premium

The premium is what changes hands when an options contract is opened. The buyer pays it and the seller — the writer — receives it. In exchange, the writer takes on the obligation to deliver or purchase the underlying security if the buyer exercises. The premium is set by supply and demand in the options market, not by the exchange or the issuer, and it fluctuates continuously while the contract is outstanding.

Options are quoted on a per-share basis, but a standard equity contract covers 100 shares. A premium quoted at 3 therefore costs $300 per contract, and one quoted at 4.50 costs $450. The premium splits into two components: intrinsic value, which is the amount by which the option is in the money, and time value, which is everything else the market is willing to pay for the possibility that the option moves further into the money before expiration. An option that is at the money or out of the money has zero intrinsic value, so its entire premium is time value.

The premium also defines the risk profile at each end of the trade. A buyer's maximum loss is the premium paid — if the option expires worthless, that is the whole loss. A writer's maximum gain is the premium received, which is why writers collect it up front but can face far larger losses if the market moves against them. Premium paid or received is also the starting point for computing break-even prices and, at expiration or closing, the capital gain or loss reported for tax purposes.

Options premiums show up throughout the securities exams. The SIE covers premiums and exercise as part of the basic options chapter, the Series 65 uses premium in options taxation and long-put strategies, and the Series 9 applies it to margin deposit requirements and taxation rules. Be ready to convert a quoted premium into total dollars and to compute break-even for calls and puts.