How Options Pricing Works — The Basics of Premium




    Options are powerful trading tools, but understanding their pricing is essential before you start. The price of an option is called the premium, and it’s influenced by several factors beyond the stock price.

What is an Option Premium?

    When you buy an option, you pay a premium to gain the right to buy (Call) or sell (Put) the underlying asset at a fixed price. Think of it as an insurance premium — you pay for potential opportunity and protection.

Components of Option Premium

  1. Intrinsic Value:

    • The real value if you exercised the option today.

    • Example: Nifty at 25,500, Call strike at 25,000 → Intrinsic value = 500.

  2. Extrinsic Value (Time Value):

    • Additional cost for time left until expiry and market uncertainty.

    • Longer expiry → higher extrinsic value.

    • More volatile markets → higher extrinsic value.

Factors That Affect Premium

  • Strike Price: The closer the strike is to the spot price, the more expensive the option.

  • Time to Expiry: More time = more opportunity to profit → higher premium.

  • Volatility: High volatility = higher chances of big moves → higher premium.

  • Interest Rates & Dividends: Minor influence, but they can tweak the premium.

Example in Action

Suppose Nifty is at 25,500:

  • 25,000 Call → ITM (Intrinsic Value + Extrinsic Value = Premium)

  • 25,500 Call → ATM (mostly extrinsic value)

  • 26,000 Call → OTM (premium purely extrinsic)

Time Decay (Theta)

    Every day, time value decreases. Buyers lose as expiry nears; sellers benefit. This is why timing is crucial. If the Nifty moves upward(in case of CE Buy), the premium will raise with certain percentage and vice-versa, if no movement the Decay will be higher which the strike approaches Expiry date.

🎯 Key Takeaway:

    Understanding premium is the first step to trading options intelligently. You’re not just betting on price movement — you’re paying for time, risk, and opportunity. That is the reason experts say Options Buying is for gamblers while tool to make money for Sellers. Theoretically Options are designed as a hedging tool while retailers use as gambling tool and we at OptionRatio use as tool to make living.