One of the best ways to profit from stock options is understanding option premium and that it’s best to sell instead of buy it. Think of a casino and how the house is much bigger than those gambling. The same goes for you and I. We profit by selling assets, not buying. Yes, the market allows you to sell before we purchase!
Option premium is the price that a buyer pays for an option contract to a seller. Option premium is priced based off of one contract that is equal to one hundred shares of a stock. For example, a contract that costs .25 is actually $25.
What is Option Premium?
Option premium is the current price of the option contract. For a buyer of an option, this is the price to which they will pay. For the writer, or seller, this is the price they will receive. You will often hear those experienced in selling options, call it; selling premium.
Learn how to sell premium and not ever own stock here in my eBook.
When an option is in-the-money, there is both intrinsic and extrinsic value. For out-of-the-money options, the price is only composed of extrinsic value.
Investors who buy call options, simply believe the stock will rise, giving them the option to purchase the asset at the strike price of which they purchased the option. On the other side of the market, investors who believe the price will drop, or want the added protection to be able to sell their shares at the strike price that they bought a put option for will have the option to do so.
How Option Premium Is Determined
You’re probably wondering how option premium is determined and what makes it higher and lower at times.
Overall, option premium is determined by multiple factors.
- Spot price of the underlying.
- Volatility in both the option and the stock.
- Time remaining of the contract
- Risk free rate of interest.
As you can see, there is not just one specific factor when options go up or down in price, or premium. The supply and demand, along with other factors create options premium to increase or decrease, thus making options a little more complex than just buying and selling stock.
I outline in detail, the best way to trade and invest in stock options here.
How To Define Break Even Points
To define the break even points when buying or selling options, you must calculate differently depending on whether it is a call or a put option.
Call Option = Strike Price + Premium amount.
Put Option = Strike Price – Premium amount.
Or use this simple Option Price Calculator.
Option Premium Decays Over Time
When investing or trading using stock options, the key is to remember that they expire at some point in time. This is called Time Decay or Theta.
Options are either in the money, or out of the money. This can change often due to the sudden change in price of the underlying stock, and therefor depending on the time frame, options can drastically change in value. As the expiration comes closer for the contract, the option eventually expires worthless if it is out of the money. This is extrinsic value.
If the option happens to be in the money, this is intrinsic value.
Example: You believe the stock price will move up, so you decide to buy 1 call option contract for $50 or .50 (Remember, 1 contract is equivalent to 100 shares) The stock price ends up dropping instead and the option is now the price of $45. Therefor a $5 loss. However, the stock then rises again, and the call option is now $60. You now are in the money, and the profit is now $10.
If you are looking to buy shares and then sell contracts against them, I would recommend my Treat Your Stocks Like Real Estate eBook.
If you are looking to just sell premium and not buy shares, I would highly recommend my How to Create Cash Flow without Owning Stock eBook.
Option Premium And Volatility
A secret that is often used for determining the option volatility is comparing its Beta to the market. This is the comparison of the market fluctuation to the stock. If the market rises, then typically is the Beta is 1, then the stock will rise the same amount as the market.
Therefor, if we are in a bull market for the day, week or whatever time frame, then the stock itself should be flowing the same as the overall market for that time frame.
Another secret that I personally use, to determine a good entry or exit point when trading or investing stock options is the comparison of IV rank to the implied volatility of today. I tend to stick to selling options that are 40-50% IV Rank.
To me, this means the option is currently 50% higher than normal. So the correct evaluation or formula for finding IV Rank, Historical Volatility, or IV can be found here.
If options are not of 50% then I know that the option premium could be higher eventually and statistics show that when selling options at 40% – 50% or higher, the likeliness to be able to buy back at much lower and profit is much higher.
Overall, options investing can be very profitable for the trader or investor who understands the factors of how options are priced.
If you are wanting to jump ahead of taking years to learn options and gather the information all in one place, you found the right place!
Feel free to pick up my two eBooks that explain everything you need to begin you stock options trading and investing.