Understanding Option Premium, Intrinsic Value and Time Value

CA Manish Singh: 
Hello everyone, and welcome to Chapter 23. In the last chapter, we discussed how options work, why they became popular in India, and how different types of traders use them. Towards the end of that video, I mentioned that options offer immense flexibility because they allow traders to participate in multiple market scenarios. 

Today, we will go deeper into one of the most important concepts in options trading: option premium. We will understand what premium is, how it is calculated, and the two components that every premium is made of. 

What Is Option Premium? 

CA Manish Singh: 
When I said earlier that you can trade options with even ten thousand rupees, that amount comes from the premium. Every option has a price called premium. When I gave the gold example in the previous chapter, you may remember that I said, “I am paying two thousand rupees as premium.” 

Premium means that by paying a small amount, I am taking exposure to a much larger contract. 

For example: 

• I pay ₹2,000 as premium
• I am getting exposure to a ₹1,00,000 contract 

If I am paying two thousand rupees, that means I am the buyer of an option, and someone else is the seller. The premium I pay goes to the seller. 

In the earlier example, the gold price eventually went to ₹1,20,000. I had paid only ₹2,000, but the seller ended up paying me ₹20,000, which means: 

• My net profit was ₹18,000
• His net loss was ₹18,000 

This is how premium works for a buyer and a seller. 

Why Option Sellers Require More Margin 

CA Manish Singh: 
Option selling requires large margin because the seller’s loss can grow significantly. If I pay only ₹2,000, the seller may lose ₹20,000. If gold went to ₹2,00,000, the seller could lose one lakh rupees. 

That is why we say option selling carries unlimited theoretical risk. In practice, traders hedge their positions, which we will learn in later chapters. 

Understanding Option Chain 

CA Manish Singh: 
Let us move to the m.Stock platform and look at the option chain. 

We will open the Option Strategy Builder and create our own strategy. 

Today, Nifty has closed at 25,461. 

We are looking at the 10th July weekly contract. As explained earlier, Nifty has weekly expiries. 

• 10th July is Thursday
• 17th July is Thursday
• 24th July is Thursday
• 31st July is the monthly expiry 

On the option chain: 

• The left side is call options
• The right side is put options 

You will see strike prices such as: 

• 25,450
• 25,400
• 25,500
• 25,550
• 25,350 

These are strike prices created at 50-point intervals for Nifty. 
Bank Nifty has 100-point intervals, and Midcap Nifty has 25-point intervals. 

These intervals are based on volatility, risk, and hedging requirements. 

Understanding Premium on the Option Chain 

You will notice: 

• Call LTP: 150
• Put LTP: 122 

This means: 

• If you buy one lot of call, you pay 150 × 75
• If you buy one lot of put, you pay 122 × 75
• If you sell one lot of call, you receive 150 × 75
• If you sell one lot of put, you receive 122 × 75 

Since the market is at 25,461 and the strike price is 25,450, the call option has intrinsic value. 

Intrinsic Value Calculation 

Intrinsic value of a call option: 

• Spot price: 25,461
• Strike price: 25,450
• Intrinsic value = 25,461 minus 25,450 = 11 

If the market expires at 25,461 at 3:30 pm on 10th July, this option will settle at ₹11. 

For puts at the same strike, intrinsic value is zero because the market is above the strike price. 

Time Value Calculation 

Premium consists of two components: 

1. Intrinsic value
2. Time value 

Time value is the part of premium that depends on the number of days left to expiry. 

For the call option: 

• Premium = 150
• Intrinsic value = 11
• Time value = 150 minus 11 = 139 

For the put option: 

• Premium = 122
• Intrinsic value = 0 (market is above strike)
• Time value = 122 

Because today is 4th July, and expiry is 10th July, there are 6 days left. 
The entire time value reflects these six days. 

If you check the monthly contract (31st July), the premium for the same strike is 371, because there are more days remaining. 

More days = higher time value = higher premium. 

Why Do Option Sellers Exist? 

Option sellers are attracted by time value decay. Over six days, the time value of 139 will reduce gradually until it becomes zero at expiry. Sellers aim to capture this decaying value. 

Buyers, on the other hand, feel that the market will move in a specific direction strongly enough to justify paying this premium. 

This is why both buyers and sellers are present in the market. 

Summary 

• Option premium = intrinsic value + time value
• Call options have intrinsic value when spot is above strike
• Put options have intrinsic value when spot is below strike
• Time value reduces with each day that passes
• Premium decay attracts option sellers
• Buyers participate when they expect strong direction
• Weekly and monthly contracts have different time values 

In the next chapter, we will understand the difference between option buyers and option sellers in detail. 

Disclaimer: Investments in securities markets are subject to market risks. Read all related documents carefully before investing.