The Options Premium
an options premium is the amount of money that investors pay for a call or put option. the two components that affect option's pricing are the intrinsic value and time value. ? is interested in road king auto, a luxury auto maker, and finds that he can buy a call option with a strike price of $40 a share. the option which expires in 30 days ? $5 premium per share. part of that $5 premium covers what is called the contract's intrinsic value. options have intrinsic value if they're in the money. for a call option, intrinsic value is calculated by subtracting the strike price from the underlying price and vice versa for put options. in this example, road king's stock currently sells for $42 a share. share price of $42 minus strike price of $40 is the option's intrinsic value which is $2. the remaining $3 of the $5 premium is the option's time value. ? could decide to buy company's stock today but he have no protection if its price ? soon after. the option offers time value because he can hold up and see how the stock performs over the next several days before choosing whether to exercise it. road king is about to introduce a new model and ? believes shares could move sharply in either direction. his potential gain is unlimited but by having the call option his total loss is caped at $5 a share, the amount of the premium. in this case, he is willing to spend $3 for ? security. as the expiration date draws closer, however, the chances of a major change in the stock price begin to fade. the time value of an option will gradually decrease until it reaches $0. by understanding these two important factors, intrinsic value and time value, ? is able to better evaluate the option's pricing and potential rewards.