Option premium
Also written Premium · Option price
The price an option buyer pays the seller for the right the contract carries — non-refundable, and made up of intrinsic value plus time value.
In plain language
An option gives its buyer a right and no obligation; the seller takes on an obligation and no right. That asymmetry has to be paid for, and the payment is the premium.
It changes hands up front and it is non-refundable. Whatever happens afterwards, the buyer's maximum loss is the premium, and the seller's maximum gain is the premium.
Nobody sets it. The workbook is blunt on this point: premiums are not fixed by the exchange or by SEBI — they are discovered by buyers and sellers, exactly as futures prices are.
How it works
Premium splits into two parts, and only one of them can be computed from today's prices:
Premium = Intrinsic value + Time value
Intrinsic value is the amount by which the option is in the money: S - X for a call and X - S for a put, floored at zero. It is never negative, so at-the-money and out-of-the-money options have none.
Time value is the rest. It exists because the option has not expired yet, and it decays to zero by expiry — non-linearly, accelerating as expiry approaches. This is why options are called wasting assets, and why the workbook notes that option sellers hold a fundamental advantage: one of the two components is inherently biased downwards.
Five variables drive the premium:
| Factor rises | Call premium | Put premium |
|---|---|---|
| Price of the underlying | Rises | Falls |
| Strike price | Falls | Rises |
| Time to expiry | Rises | Rises |
| Volatility | Rises | Rises |
| Interest rate | Rises | Falls |
The formula
Premium = Intrinsic value + Time value
Intrinsic value of a call = max(Spot - Strike, 0)
Intrinsic value of a put = max(Strike - Spot, 0)
Time value = Premium - Intrinsic value
A worked example
The workbook's zinc option. Strike Rs 180, call premium Rs 10, put premium Rs 8, one month to expiry.
At expiry, per unit:
| Market price | Call buyer | Call seller | Put buyer | Put seller |
|---|---|---|---|---|
| 220 | +Rs 30 | −Rs 30 | −Rs 8 | +Rs 8 |
| 200 | +Rs 10 | −Rs 10 | −Rs 8 | +Rs 8 |
| 160 | −Rs 10 | +Rs 10 | +Rs 12 | −Rs 12 |
| 140 | −Rs 10 | +Rs 10 | +Rs 32 | −Rs 32 |
Read the call column downwards. Below Rs 180 the call buyer's loss stops at Rs 10 however far the market falls — the premium, and nothing more. The call seller's gain stops at the same Rs 10 however far it falls.
Now split a live premium. A commodity future is at Rs 1,280, and an option on it quotes a premium of Rs 200 against a strike of Rs 1,150:
Intrinsic value = 1,280 - 1,150 = Rs 130
Time value = 200 - 130 = Rs 70
Rs 70 of that Rs 200 is being paid purely for time remaining, and it is gone by expiry even if the future never moves.
Why NISM asks about it
Chapter 4 (Commodity Options), section 4.2 for the terminology and section 4.4 for the determinants — the factor table above is reproduced almost verbatim in the workbook and is examined directly. Expect "split this premium into intrinsic and time value" arithmetic, a question on which way a rise in interest rates moves a put premium (down), and the payoff table logic that the buyer's loss is capped at the premium.
Common exam traps
- The premium is not the strike price. The strike is the price at which the commodity changes hands; the premium is what the right to that strike costs.
- Intrinsic value can never be negative. An out-of-the-money option has zero intrinsic value and its entire premium is time value.
- Time to expiry raises both call and put premiums, unlike the underlying price, which moves them in opposite directions.
- Time decay is not linear — it accelerates towards expiry, so a one-month option is worth considerably more than half a two-month option.
- The premium is non-refundable. Letting an option lapse unexercised does not return it.
- Rising interest rates lift calls and depress puts. Volatility, by contrast, lifts both.
Where this is taught
- Series XVI · Chapter 1: Introduction to Commodity Marketsintroduced here
- Series V-D · Chapter 21: Exchange Traded Interest Rate Optionsintroduced here
- Series VIII · Chapter 4: Introduction to Optionsintroduced here
- Series XII · Chapter 6: Derivative Marketsintroduced here
- Series IV · Chapter 4: Exchange Traded Interest Rate Optionsintroduced here
- Series XVI · Chapter 4: Commodity Options
Related terms
- Intrinsic valueWhat an asset is actually worth — the present value of the cash it will generate over its remaining life, as against whatever price the market is quoting today.
- Call optionA contract giving its buyer the right, but never the obligation, to buy the underlying at a fixed strike price — so the loss is capped at the premium and the gain is not.
- Implied volatilityThe volatility figure that, put into an option pricing model, reproduces the option's actual market price — the market's consensus forecast of how much the underlying will move.
- Strike priceThe price fixed in an option contract at which the buyer may buy (call) or sell (put) the underlying if he chooses to exercise — fixed for the life of the contract, unlike the premium.
- Time valueThe premium less the intrinsic value. It falls to zero by expiry, which is why options are called wasting assets.
- Put optionA contract giving its buyer the right, but never the obligation, to sell the underlying at a fixed strike price — insurance against a fall, bought for a premium.
- Wasting assetAn option, whose time value shrinks towards zero every day it is held and is worth nothing at expiry — so an option buyer loses money simply from the passage of time.
- OptionA contract giving the buyer the right, but not the obligation, to buy or sell the underlying at a stated price on or before a stated date, in exchange for a premium paid to the writer.
- Commodity Transaction TaxA transaction tax on non-agricultural commodity derivatives — 0.01% on the sale of a futures contract, paid by the seller, with separate rates for options.
- Break-even pointThe level of the underlying at which a position makes neither profit nor loss — for a bought call, strike plus premium; for a bought put, strike minus premium.
- DeltaThe change in an option's premium for a one-rupee change in the underlying — the first and most used Greek, and the hedge ratio that says how much underlying to hold against an option position.
- LeverageControl of a large contract value for a small upfront outlay — premium for an option buyer, margin for a futures position — which multiplies percentage gains and percentage losses by the same factor.
- Securities Transaction TaxA central government tax collected by the exchange on the sell side of every futures and option trade — 0.05% of futures traded value, 0.15% of option premium, and 0.15% of settlement price on exercise.
- InsuranceThe risk-management approach that pays an explicit upfront premium to remove the downside while keeping the upside — which in derivatives means buying an option rather than selling a future.
- MoneynessWhether exercising an option right now would give the buyer a positive, zero or negative cash flow — classifying it as in the money, at the money or out of the money.
- Horizontal spreadTwo options of the same type and the same strike but different expiries — a position whose entire value is the difference between the two legs' time values, not a view on direction.
- Diagonal spreadTwo options of the same type on the same underlying with both a different strike and a different expiry — the most complicated of the three spread families, and the only one that varies on both axes.