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Options Premium - Definition
Options Premium is the price of an options contract.
Options Premium - Introduction
What is Options Premium? Is it like an insurance premium? How is does that work in options trading?
Options Premium is one of those terms that are always mentioned in options trading but few people know what it really means. In fact, options premium is one options trading term that has been used to mean very different things by different teachers or education materials and has caused considerable confusion. However, due to the widespread use of the term "Options Premium", options traders must know exactly what it means in order to make sense of the many options lectures or lessons out there.
This tutorial shall explain the different meanings of Options Premium and how it affect your options trading.
What Is Options Premium?
Options premium has been used loosely to refer to the price of an option. Some options guru say you pay "Options Premium" to buy an option and some options guru also say you gain "Options Premium" when you write an option. However, this is exactly where it gets confusing. The pricing of an option is actually made up of two parts; Intrinsic Value and Extrinsic Value (read more about Options Pricing). You pay the whole price of an option when you buy an option but you really only gain the extrinsic value as profit when you write options if the price of the stock remains stable. The term "Options Premium" has been used interchangably by many options experts to refer to the overall price of an option and the "Extrinsic Value" of an option. As such, options premium can mean:
1. The Whole Price of an Option
That's right. There is no standardization as to the exact meaning of the term "Options Premium" and you can still hear options experts on TV using the term to mean either one of the above interchangably. This is why it is very important to clarify the meaning of what "Options Premium" mean with the person delivering the options training particularly in the area of options spreads where the distinction between extrinsic value and the whole price of an option is extremely important.
Options Premium: Whole Price of an Option
When most of the experts on TV talk about the term "Options Premium" in general talks about investment alternatives, they usually mean the whole price of an option. Statements such as "You pay a premium of $X for a call option" or "You pay an options premium to buy an option" usually refers to the whole price of an option. The rationale behind using the term "Options Premium" in this way is in reference to options being like insurance where you pay a "premium" for the coverage. In this context, options premium usually mean the "Asking Price" of an option (read more about Options Prices).
Options Premium: Extrinsic Value of an Option
When talking about options pricing, writing options or options strategies, the term "Options Premium" is widely used to refer to the "Extrinsic Value" of an option. Statements such as "You earn the premium when you write an option" or "The premium value decays over time" usually refers to the extrinsic value of an option. The rationale behind using the term "Options Premium" in this way stems from the idea that you pay a "premium" over its intrinsic value, hence extrinsic value is also known as "premium value".