Option Premium

Option Premium is the upfront payment made by the option buyer to the option seller to acquire the option. Premium is paid by the option buyer, as the cost of the right that he receives after purchasing an option. It is also known as the option price. The option price is mainly determined by two components intrinsic value and time value. After the premium is paid, it is considered as a sunk cost as it is non-refundable even if the buyer does not exercise his right.

 

Example: Suppose George, an investor wants to buy a call option of X=$70 on Microsoft shares. Each contract’s size is of 100 shares, at a premium of $ 2.5 per share and maturity of six months. In order to buy one contract, George has to pay a total premium of $ 250 (2.5 X 100).