An option’s premium is calculated based on several factors:
- Intrinsic Value: This is the difference between the underlying asset’s current price and the option’s strike price. A call option is the amount by which the asset’s price exceeds the strike price. For a put option, it’s the amount by which the strike price exceeds the asset’s price.
- Time Value: This represents the potential for the option to gain value before its expiry. The more time until the option’s expiration, the higher the time value.
- Volatility: If the underlying asset’s price is more volatile, the option’s premium will be higher because the potential for gain (or loss) is more significant.
- Interest Rates: Higher interest rates increase the cost of holding cash compared to investing it and can increase the option’s premium.
- Dividends: If the underlying asset pays dividends, the option’s premium can be affected. Call premiums decrease, and put premiums increase when a dividend is expected.
- Demand and Supply: Market demand and supply forces also affect an option’s premium.
These factors are often combined in models like the Black-Scholes Model or the Binomial Options Pricing Model to calculate an option’s premium.