Call premiums are a concept in options trading that represents the price an investor pays for the right to exercise their option at a future date. Call premiums also exist in bonds trading, accounting for the loss of future income when an issuer buys back or “calls” the security before its expiration date.
Options Trading Types
Writers from The Corporate Finance Institute explain that an option is a contract that allows you to buy or sell the underlying asset (such as shares) at a previously agreed-upon price no matter the asset’s current market value. Options have expiry dates past which the option cannot be exercised and grant the right but not the obligation to trade at the set price, called the strike price.
Options are a way for investors to reduce their risk while maximizing their potential profit. To compensate, the option premium is the price paid for the right to exercise the option. There are two types of options in the market: call options and put options.
What Is a Call Option?
A call option gives you the right to buy the underlying asset at the strike price. It is used when you expect the value of the underlying asset to rise. For example, if your option contract for Company A specifies a strike price of $20/share for 100 shares and the market price rises to $30/share, you can exercise your option and buy 100 shares for $2,000.
You can then immediately sell these shares at the market value of $30/share for $3,000. That’s a profit of $1,000. Of course, this right is not free. The option itself is purchased for a price, which in this case is the call premium. Supposing you paid $200 for the option, your net profit is $1,000 minus the option premium, or $800.
The other type of option is a put option, which works just like a call option but for selling at a set price instead of buying at a set price. This type of option protects against falling prices, such that if the asset’s market value falls below its strike price, you can still sell at the higher price before the expiration date.
How Premiums Work
If you’re trading in options, it’s essential to understand option premiums. The price paid for an option, or the option premium, is key in determining if a given option is a good investment. IG, an online trading provider, explains that the option premium formula is: Premium = intrinsic value + time value.
Nasdaq adds a third component: the volatility value. Therefore, if a call option has an intrinsic value of $20 and a time value of $30, you will need to exercise the option when the market value is more than $50 above the strike price to make a profit.
The team at ValuePenguin goes into more depth to explain intrinsic value and time value. The intrinsic value of an option represents its current value in the market, also known as how “in the money” it is. It is the current price of the asset less the strike price. If the current value of the asset is below the strike price, then the intrinsic value is always zero, because you would never exercise a call option in this scenario. Instead, buyers let these options expire. Time value represents the length of time the underlying market has to pass the strike price. A longer time to expiry comes with a higher time value.
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