An option premium is an income received by an investor who sells or "writes" an option contract to another party. An option premium may also refer to the current price of any specific option contract that has yet to expire. For stock options, the premium is quoted as a dollar amount per share, and most contracts represent the commitment of 100 shares.

Premiums are quoted on a per-share basis because most options contracts represent 100 shares of the underlying stock. Thus, a premium that is quoted as $0.10 means that the option contract will cost $10.

Whether an investor wants to buy or sell options, understanding what makes up an option’s premium is crucial in trading options. Intrinsic value, time value and implied volatility are the three components that determine the price of an option premium. Knowing what these components are and how they affect an option’s premium will help investors recognize a good deal from a bad deal in option contracts.

Intrinsic Value

The intrinsic value of an option contract is the difference between the strike price and the market price of the underlying stock.

For example, assume Disney (NYSE: DIS) has a market price of $105. If an investor buys a call option for DIS with a strike price of $100, then it has an intrinsic value of $5. This is known to be “in-the-money.” An investor could buy this option and reap a $500 profit right away.

If an investor buys a call option for DIS with a strike price of $100, but the market price of DIS is $95, then there is no intrinsic value. This is known as being “out-of-the-money.”

The farther “in-the-money” an option is, the more expensive the premium will be.

Time Value

The time value of an option contract is dependent upon the length of time remaining before the option contract expires.

The more time an option has until expiration, the greater the time value is. As the option approaches its expiration date, the time value decreases. When the option expires, it becomes worthless.

Understanding how these three factors affect option premiums will prepare investors to differentiate between reasonable and unreasonable option premiums. This understanding will increase investors’ chances of getting a big return on investment from trading options.

Implied Volatility

Implied volatility is derived from the option's price, which is plugged into an option's pricing model to indicate how volatile a stock's price may be in the future. Moreover, it affects the extrinsic value portion of option premiums. If investors are long options, an increase in implied volatility would add to the value. The opposite is true if implied volatility decreases. For example, assume an investor is long one call option with an annualized implied volatility of 20%. Therefore, if the implied volatility increases to 50% during the option's life, the call option premium would appreciate in value.