Premium

What is Premium?

Premium Premium is the total price paid for an option contract — the dollar amount the buyer pays the seller per share, typically multiplied by 100 shares per contract. A call premium of $2.50 means the buyer pays $250 total per contract. Premium is composed of two parts: intrinsic value and extrinsic (time) value. **Intrinsic value** is the amount by which an option is in-the-money. For a call with strike $100 and stock at $105, intrinsic value is $5. For OTM options, intrinsic value is zero. Intrinsic value cannot be negative. **Extrinsic value** (also called time value) is the rest of the premium — what's left after intrinsic value is removed. It represents the time value plus implied volatility component. Extrinsic value decays to zero by expiration (this is theta decay). Premium decomposition example: AAPL at $185, $180 call trading at $7.50. Intrinsic = $5 (the $5 ITM portion). Extrinsic = $2.50 (the time/vol value). At expiration, the call is worth exactly $5 (its intrinsic value); the $2.50 extrinsic decays to zero. Premium magnitude depends on five factors: 1. **Moneyness**: ITM options have larger absolute premium (because of intrinsic value); ATM and OTM premiums are pure extrinsic. 2. **Time to expiration**: longer-dated options have more extrinsic value. A 90-DTE option is more expensive than a 7-DTE option at the same strike. 3. **Implied volatility**: higher IV expands extrinsic value. The same option costs more in high-IV regimes. 4. **Interest rates**: minor effect (rho); calls are slightly more expensive at higher rates, puts slightly less. 5. **Dividends**: dividend-paying stocks have slightly lower call premiums and higher put premiums. For options buyers, premium is the entire risk capital — maximum loss equals the premium paid. For options sellers, premium is the maximum profit, with risk extending beyond the credit received (sometimes unlimited). Premium-selling strategies (covered calls, cash-secured puts, iron condors, credit spreads) generate income from theta decay and IV contraction. Premium-buying strategies (long calls, long puts, debit spreads) need directional moves or vol expansion to overcome the time-value erosion of premium. The relationship between premium and probability of profit is structural: higher premium typically means lower probability of profit. A $5 wide credit spread that pays $1.50 credit has a higher probability of profit than one that pays $2.50 credit — the more you collect, the closer to ATM your short strike, and the more often the trade goes against you.