What is option premium
An option premium is the price the buyer of an option pays the seller for the right, but not the obligation, to buy or sell an underlying asset at a fixed price before or on a set date.
The buyer pays the premium when the option is opened. The seller (also called the writer) keeps it whatever happens next. For the buyer, the premium is the most that can be lost on a bought option. For the seller, the premium is the most that can be gained, while the possible loss can be much larger.
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Worked example (hypothetical)
Take a call option on a share. A call is the right to buy. Use letters instead of real prices:
| Item | Symbol | Meaning |
|---|---|---|
| Share price now | S | Market price of the underlying |
| Strike price | K | Price at which the buyer may buy |
| Quoted premium | P | Price per share shown on the screen |
| Contract size | N | Shares covered by the contract (contract size) |
- Total premium paid = P × N.
- Intrinsic value of the call = S − K if S is above K. Otherwise it is zero.
- Time value = P − intrinsic value. This is what the buyer pays for the chance that the price moves further before the expiry date.
If S is below K, the call has no intrinsic value, so the whole premium is time value. If nothing changes until expiry, time value falls to zero and the buyer loses the full P × N.
What drives option pricing
The premium depends on:
- the underlying price relative to the strike
- the time left to expiry
- expected volatility of the underlying, known as implied volatility (see annualized volatility)
- interest rates and expected dividends
Models such as Black-Scholes or binomial trees combine these inputs into a theoretical premium. The market price can differ from the model price because of supply and demand. Delta shows how much the premium changes when the underlying moves.
Formal definition and edge cases
Formally, the premium is the market value of the option contract. It equals intrinsic value plus time (extrinsic) value.
- At expiry, the premium equals intrinsic value only.
- American-style options, which can be exercised early, should not trade below intrinsic value. If they did, an arbitrage would exist.
- European-style options, which can only be exercised at expiry, can trade below intrinsic value. This happens, for example, with deep in-the-money calls before a large dividend, or puts when interest rates are high.
- Bid and ask premiums differ. The spread between them is a cost, and it is often wide on illiquid strikes.
- Other meanings of "premium": a bond "at a premium" trades above face value, and a futures price above spot is also called a premium. These are different ideas from the option premium.
Where you see the term
- Option chains on exchange platforms: bid, ask and last premium for each strike and expiry.
- Trade confirmations and account statements: premium paid or received, shown as a debit or credit.
- News: "call premiums rose" usually means implied volatility or demand went up.
In Pakistan, the SECP states that offshore platforms offering instruments such as forex and options operate without approval: per the SECP, offshore forex/CFD platforms operate without regulatory approval in Pakistan. See Regulation and Safety for details. Sold options and leveraged derivatives can lose money fast. Read risk management before trading any derivative.
Related terms
Call option · Delta · Expiry date · Forward contract · Counterparty · Trading glossary
Frequent questions
What does option premium mean in simple words?
It is the price of the option: what the buyer pays and the seller receives.
Is the premium refunded if the option is not used?
No. The seller keeps the premium whether or not the option is exercised.
Why do options with the same strike have different premiums?
They have different times to expiry. More time usually means more time value.
Can the premium be zero?
Close to zero, yes. A far out-of-the-money option near expiry can be quoted at almost nothing, but sellers rarely offer it free.