Option premium is the price paid by the buyer to the seller (writer) for the option contract, representing the total cost to own the right to buy or sell the underlying asset.
Understanding Option Premium
When you buy an option, you pay a premium. This is the only thing you pay upfront. It’s your total risk (if option expires worthless).
Example: You buy a EUR/USD 1.1100 call option for a $500 premium. You pay $500 immediately. This is your cost basis. Your maximum loss is $500 (if option expires worthless).
The premium has two components:
- Intrinsic value: The immediate profit if exercised
- Time value: The extra cost for probability of bigger moves before expiration
Intrinsic Value Component
Intrinsic value is the “real” value of the option if exercised immediately.
For calls: Intrinsic = Max(0, Current Price - Strike Price)
- EUR/USD 1.1100 call when price is 1.1200: Intrinsic = 100 pips = part of premium
- EUR/USD 1.1100 call when price is 1.1000: Intrinsic = 0 pips (out of the money)
For puts: Intrinsic = Max(0, Strike Price - Current Price)
- EUR/USD 1.1000 put when price is 1.0900: Intrinsic = 100 pips = part of premium
- EUR/USD 1.1000 put when price is 1.1100: Intrinsic = 0 pips
Time Value Component
Time value is the premium paid beyond intrinsic value. It represents the probability of bigger favorable moves before expiration.
Example:
- EUR/USD call: 1.1100 strike, current price 1.1000
- Intrinsic value: 0 pips (out of the money)
- Total premium: $500 = 5 pips (in option pricing)
- Time value: 5 pips (the entire premium is time value)
The further from expiration, the more time value. The closer to expiration, the less time value (theta decay).
Factors That Affect Premium
1. Strike distance (Delta): How in/out of money the option is. ATM options have highest premium. Deep ITM or OTM have lower premium.
2. Volatility (Vega): High volatility = high premium. Low volatility = low premium. Before announcements (high uncertainty), premiums spike.
3. Time to expiration (Theta): More time = higher premium. Less time = lower premium. Decay accelerates approaching expiration.
4. Interest rates (Rho): Less relevant in forex, but affects long-term option pricing.
5. Underlying price movement: Recent large moves = higher volatility expectations = higher premium.
Premium Decay Over Time
An option losing value as it ages—this is theta decay.
Example: You buy a call for $500 premium, 1 month to expiration.
- Day 1: Premium $500, time value $300
- Day 15: Premium $350, time value $150
- Day 25: Premium $100, time value $20
- Day 30: Premium $5, time value $0 (only intrinsic remains)
Unless the underlying price moves favorably, you’re losing money daily. This is why holding options to expiration (in a non-trending market) is a losing proposition.
Solution: Exit options 7-14 days before expiration, not at expiration. You preserve some time value instead of losing it all to decay.
Premium and Entry Strategy
Smart traders don’t just care about direction—they care about premium levels:
Buy options when premium is low: After big moves (volatility has expired), premiums drop. Buying cheap options that then rise with renewed volatility creates profits without direction move.
Sell/short options when premium is high: Before major announcements (uncertainty priced in), premiums spike. Selling (writing) options to collect expensive premiums, betting volatility won’t materialize.
Most retail traders ignore this. They just buy or sell based on direction. Professionals trade premium levels—buying cheap, selling expensive.
Example: Trading Premium
Setup: EUR/USD flat 1.1000 for 2 weeks. Call options at 1.1100 strike are trading for $300 premium (low because no volatility).
Decision: Buy calls at $300 premium, betting on volatility return (not direction move yet).
Major announcement tomorrow could spike volatility. If volatility rises to expected levels, that same call might be worth $600 premium (without EUR/USD moving).
You bought at $300, can sell at $600 tomorrow. $300 profit without direction move.
This is volatility arbitrage—trading premium level, not direction.
Premium and Position Sizing
Since premium is your maximum loss, it directly determines position sizing:
Using position size calculator for options:
Account: $5,000. Risk per trade: 1% = $50 max loss.
Option premium: $300. How many options can you buy?
$50 / $300 per contract = 0.17 contracts = you can buy 1 contract and lose $300 max.
This exceeds your 1% risk rule. Better to buy 0.17 contracts (fractional) or skip the trade.
Selling Options and Premium Collection
Selling (writing) options is the flip side: you collect premium, but take on risk.
If you sell a call for $500 premium, you immediately have $500 profit (premium collected). But you’re obligated to deliver if exercised.
- Sell call: Collect premium, but unlimited loss risk if price spikes
- Sell put: Collect premium, but risk of forced buy (capital requirement)
Selling options is advanced and has unlimited loss potential. Most retail traders buy options (limited loss) rather than sell (unlimited loss).
Real Example: Premium Dynamics
Scenario: You buy EUR/USD 1.1100 call when price is 1.1000.
Premium paid: $400 (time value mostly)
Day 1: EUR/USD drops to 1.0950. Volatility remains same. Premium collapses to $100 (time value + negative movement).
Loss so far: $300 on $400 premium = you lose 75%.
Day 3: EUR/USD rallies to 1.1050. Volatility spikes due to news. Premium jumps to $600.
Profit so far: $200 on $400 premium = you’re up 50%.
Same movement (100 pips off your entry) yields different results based on volatility. This is vega (volatility sensitivity).
Building Premium Judgment
After 20-30 option trades, log:
- Premium you paid at entry
- Option value at exit
- How much time passed
- Did premium increase/decrease? Why?
- Could you have timed entry better (bought cheaper)?
Develop intuition: When are premiums cheap (buying opportunity)? When are they expensive (avoid buying, or consider selling)?
This premium awareness is where sophisticated option traders develop edge—not through direction prediction, but through premium timing.
Premium is your insurance cost. Buy it cheap, use it wisely.
