Option Premium
The option premium is the price the buyer pays the seller for an option; it is the most an option buyer can lose.
Every option trade starts with a price: the premium. For the buyer it is the cost of the right and the most they can lose. For the seller it is income — and the most they can make. Knowing what goes into that price tells you whether you are paying for something real or for hope.
- Category
- Derivatives
- Reading time
- 4 min
- Also called
- Options premium, Option price
- Updated
Premium in plain words
When you buy an option, the price you pay is the premium; when you sell, it is what you receive, and it changes constantly.1
For the buyer, the premium paid is the maximum loss; for the seller, the premium received is the maximum profit.2
The premium has two parts: intrinsic value and time value.3 See Options.
How to read an option premium, step by step
Note the quoted price
A standard-size contract covers 100 shares, so multiply the quoted premium by 100.2
Work out intrinsic value
Intrinsic value exists only when the option is in the money.2
Find time value
Time value is any premium above intrinsic value before expiration.3
Consider what drives it
Underlying price, strike, time to expiry, implied volatility, dividends and interest rates all affect the premium.3
Expect time decay
As expiration approaches, time value generally erodes for both puts and calls.3
Know your maximum loss
As a buyer, the premium is the most you can lose.2
Worked examples
Example 1 — Buyer's maximum loss
Max loss $300You buy one call at a premium of $3.00.
| Cost | $3.00 × 100 = $300 |
| Worst case at expiry | Option expires worthless |
| Maximum loss | $300 |
For the buyer, the premium is the most that can be lost.2
Example 2 — Splitting the premium
$5 intrinsic + $2 timeA call with a $100 strike trades at $7.00 while the stock is $105.
| Intrinsic value | $105 − $100 = $5.00 |
| Time value | $7.00 − $5.00 = $2.00 |
Intrinsic value is what the option is worth in the money; time value is any premium above that before expiration.3
Example 3 — Seller's side
+$250 keptYou sell one put and collect a premium of $2.50. The stock stays above the strike.
| Premium received | $2.50 × 100 = $250 |
| Option at expiry | Expires worthless |
| Profit | $250 (the maximum) |
For the seller, the premium received at the time of sale is the maximum profit.2
Premium for buyers vs sellers
| Aspect | Buyer | Seller |
|---|---|---|
| Cash flow | Pays the premium | Receives the premium |
| Maximum profit | Can be large | The premium |
| Maximum loss | The premium | Can be large; unlimited for a naked call |
| Effect of time decay | Hurts | Helps |
Why the premium matters
Defining risk
A bought option caps your loss at the premium.
Generating income
Option sellers collect premium in exchange for taking risk.
Judging value
Comparing intrinsic and time value shows what you are paying for.
Planning break-even
The premium sets the Break-Even point of a trade.
Advantages and disadvantages
Advantages
- Known, limited cost for option buyers.
- Small outlay compared with buying the shares — a form of Leverage.
- Transparent price that splits into intrinsic and time value.
Disadvantages
- Buyers can lose the whole premium.
- Time value erodes as expiration approaches.
- Higher volatility makes premiums more expensive.
- Sellers' income is capped while losses can be large.
Going deeper
Read as far as you need. Each level builds on the one before it.
Price of the right
Beginner
The premium is what you pay or receive for an option, and it changes all the time.1
What sets the price
Intermediate
Common mistakes
Forgetting the multiplier
A $3 premium usually costs $300 per contract.
Overpaying for time value
Buying options rich in time value right before it decays.
Ignoring volatility
Paying a high premium just before volatility drops.
Selling naked without a plan
A naked call's loss is theoretically unlimited.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- The premium is the option's price, paid by the buyer to the seller.
- For buyers it is the maximum loss; for sellers the maximum profit.
- Premium = intrinsic value + time value.
- Time, volatility and moneyness drive it.
- Time value erodes as expiration approaches.
Frequently asked questions
Is the premium refundable?
Why do premiums rise before earnings?
Can an option be worth less than its intrinsic value?
Further learning
- Options
The basics of calls and puts.
- Implied Volatility
A key driver of premium.
- Break-Even
How premium sets the break-even price.
- Leverage
Why a small premium controls a larger position.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Options Industry Council (OCC). What is an Option? (opens in a new tab) Checked .
- FINRA. Options (opens in a new tab) Checked .
- Options Industry Council (OCC). Options Pricing (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.