Premium
The option premium is the price the buyer pays to the writer in exchange for the rights conveyed by the contract. It splits cleanly into intrinsic value plus time value. Premium is paid upfront, is non-refundable, and equals the buyer's maximum loss. The five drivers of premium are the spot price , the strike , the time to expiry , the volatility , and the risk-free rate . Black-Scholes-Merton (1973) ties them together formally.
Why it matters
The premium is the price tag for a one-sided right. Two forces set it. The first is how much money the option would pay if exercised right now, which is intrinsic value. The second is how much could change before expiry, which is time value. A deeply in-the-money option is mostly intrinsic value, so it trades close to its immediate exercise payoff. An at-the-money option with months to run is almost all time value, because no one knows yet whether it will finish in or out of the money.
Formulas
Worked examples
A 3-month CBA call has strike 50, current stock 53C = $5$.
Intrinsic value 3$. Time value 2$. The $2 of time value reflects the chance that CBA rises further before expiry, plus a small adjustment for the cost of carry on .
Same call as above one second before expiry, with 53$.
Time value collapses to $0= $3$. The $2 of time value has fully decayed. This decay is called theta and is why option writers earn the time premium if the spot stays put.
Common mistakes
- ✗The premium is refunded if you do not exercise. The premium is non-refundable. It is paid to the writer at trade inception in exchange for accepting the obligation, and it stays with the writer regardless of outcome.
- ✗Out-of-the-money options have zero premium. OTM options have zero intrinsic value but positive time value while time remains. They can still be valuable for cheap directional bets or as tail-risk hedges.
- ✗Higher premium means a better deal. Premium depends on , , and , so a higher premium often just means more time or higher volatility. The right comparison is relative to fair value from a pricing model, not the dollar premium itself.
Revision bullets
- •Premium intrinsic value time value
- •Paid by buyer to writer at trade inception
- •Non-refundable and equals buyer's max loss
- •Time value decays as shrinks (theta)
- •Drivers are , , , ,
Quick check
An option's time value is zero when:
A call has 40K = $366. The time value is:
Connected topics
In learning paths
Sources
- Hull, John C. Options, Futures, and Other Derivatives. 11th ed. Pearson, 2022. ISBN 978-0-13-693997-9.Sections on properties of stock options establish the premium decomposition and the six factors affecting option prices.
- Black, Fischer, and Myron Scholes. "The Pricing of Options and Corporate Liabilities." Journal of Political Economy, vol. 81, no. 3, 1973, pp. 637 to 654.Original closed-form pricing of European options. Provides the formal link between premium and the parameters $S$, $K$, $T$, $\sigma$, $r$.
- Cboe Global Markets. Options Trading Glossary. Cboe Options Institute, accessed 2026.Plain-English definition of premium, intrinsic value, time value, and theta decay used in US listed markets.
- Australian Securities Exchange. Online Options Course, Module 4: Option Pricing Fundamentals. ASX Investor Education, accessed 2026.Local teaching reference linking premium to intrinsic and time value for ASX-listed options.