Premium is the total amount of money (price) you pay for an
option. So, if the Microsoft (MSFT) May 65 calls cost you $1.50
then the $1.50 is the amount of the premium of the option.
The total price of an option (premium) consists of two
components. Those two components are intrinsic value and
extrinsic value.
Please view charts below for option price (premium) examples.
Intrinsic value, also called parity, is the amount by which an
option is in the money. In the case of a call, the intrinsic
value is equal to the present stock price minus the strike
price. In the case of a put, the intrinsic value is equal to the
strike price minus the present stock price. Only in-the-money
options have intrinsic value. Out-of-the-money options have no
intrinsic value.
For example, with MSFT trading at $65.00, the MSFT January 60
calls will have $5.00 of intrinsic value. If the MSFT January 60
calls were trading at $5.70, then $5.00 of that premium would be
intrinsic value.
At the same time, the MSFT January 70 put will also have $5.00
of intrinsic value. So, if the MSFT January 70 puts were trading
for $5.70, then $5.00 of that premium would be intrinsic value.
Please view charts below for intrinsic value examples.
Extrinsic value is defined as the price of an option less its
intrinsic value. In the case of out-of-the-money options, the
options entire price consists only of extrinsic value.
Extrinsic value is made up of several components, with the
largest being volatility.
In the examples above, if the MSFT January 60 calls were trading
at $5.70 and $5.00 of that was intrinsic value, then the
remainder ($.70) is extrinsic value. The same also holds true
for the January 70 puts. If they were trading at $5.70 and $5.00
of that was intrinsic value, then the rest ($.70) is extrinsic
value.
Please view charts below for extrinsic value examples.
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