In simple terms, options are contracts which give its owner the right to buy or sell a security at a specific price on a specified date.
Remember, option contracts provide the buyer with the right, but not the obligation, to buy and sell an underlying security at the strike price.
These option contracts with an expiry date trades on exchanges. Its part of the derivative market as these contracts derive their value from the price of the underlying security or stock.
Option prices, which are also known as premiums, fluctuate based on how the underlying security performs in the market.
Option prices or premiums basically composed of the sum of its intrinsic and time value.
Option premium = intrinsic value + time value
Intrinsic value is the difference between the current price and strike price.
The amount of premium over the underlying security’s intrinsic value is known as option’s time value or extrinsic value.
Time value will always be high when the expiry date is far away. It will also be high when traders and investors are thinking that the contract will be profitable.
An option buyer will always buy a call option when the underlying security’s price rises. On the other hand, a trader will prefer to buy a put option when the stock’s price is falling.
Here are the factors which define the profitability of an option contract and premiums;
- the stock option price or premium
- how much time is remaining until the contract expires, also known as time value
- how much the underlying security or stock fluctuates in value.
- intrinsic value
- time decay
