Understanding Premium & Pricing

Premium is the price of an options contract: what the buyer pays and the seller collects. It's quoted per share, so a $3.00 premium actually costs $300 per contract (100 shares).

Premium has two components:

Intrinsic value + Extrinsic value = Total premium

Intrinsic value is the real, tangible profit if you exercised the option right now.

For calls: Intrinsic = Stock price - Strike price (if positive)

• $55 call when stock is at $60 → $5 intrinsic value

For puts: Intrinsic = Strike price - Stock price (if positive)

• $50 put when stock is at $45 → $5 intrinsic value

OTM options have zero intrinsic value. Their premium is 100% extrinsic.

Extrinsic value is everything beyond intrinsic value. It represents the probability that the option could become more valuable before expiration.

Three factors drive extrinsic value:

Time remaining: More time = more extrinsic value. This is why longer-dated options cost more.

Implied volatility (IV): Higher IV = more extrinsic value. Volatile stocks have expensive options because there's a bigger chance of large moves.

Proximity to the money: ATM options have the most extrinsic value because the outcome is most uncertain.

Extrinsic value decays to zero by expiration. This decay is what premium sellers harvest as income.

The bid-ask spread is the difference between what buyers will pay (bid) and what sellers want (ask).

Tight spread (liquid options): Bid $3.00 / Ask $3.05 → $0.05 spread

Wide spread (illiquid options): Bid $1.00 / Ask $1.50 → $0.50 spread

The spread is a hidden cost. On a wide-spread option, you lose $50 per contract the moment you enter. This is why liquidity matters. Stick to stocks with tight options spreads.