The Two Components of Premium
Intrinsic value is the amount an option is in the money. If a stock trades at $155 and you hold a $150 call, the intrinsic value is $5.00. An out-of-the-money option has zero intrinsic value.
Extrinsic value (also called time value) is the remainder. If that $150 call is priced at $8.00 and has $5.00 of intrinsic value, the extrinsic value is $3.00.
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Out-of-the-money options are 100% extrinsic value. That's pure time and volatility premium.
The Six Factors That Drive Premium
1. Stock price relative to strike. The further in the money, the more expensive. An AAPL $170 call with the stock at $190 costs far more than a $210 call.
2. Time to expiration. More time = higher premium. A 60-day option costs roughly 40% more than a 30-day option at the same strike, all else equal. Time decays non-linearly — the last two weeks see the steepest decline.
3. Implied volatility (IV). Higher IV means higher premiums. Before earnings, IV might spike 30–50%, inflating premiums. After the announcement, IV collapses ("IV crush"), deflating them.
4. Interest rates. Higher rates slightly increase call premiums and decrease put premiums. This effect is minor for short-dated options but noticeable on LEAPS (long-term options).
5. Dividends. Upcoming dividends decrease call premiums and increase put premiums, because the stock price drops by the dividend amount on the ex-date.
6. Supply and demand. Heavy buying pressure on calls (like before a rumored buyout) inflates premiums beyond what the model predicts.
How Options Are Priced: Black-Scholes in Plain English
The Black-Scholes model is the standard formula for pricing European-style options. Without the math, here's what it does:
It calculates the probability that an option will expire in the money, adjusts for the magnitude of the payoff, and discounts it back to today's value. The key input that traders argue about is implied volatility — everyone agrees on the stock price, strike, time, and interest rate, but IV is the market's collective guess about future uncertainty.
When someone says an option is "cheap" or "expensive," they're comparing its implied volatility to the stock's historical volatility. An IV of 40% on a stock that typically moves 25% means options are priced expensively.
Why Premium Matters for Different Strategies
If you're buying options, premium is your cost and max risk. You want to buy when premiums are relatively low (low IV) and profit from a move or IV expansion.
If you're selling options, premium is your income. You want to sell when premiums are relatively high (high IV) because time decay works in your favor, and you profit as the inflated premium deflates.
This is why strategies like covered calls and cash-secured puts tend to perform best during periods of elevated volatility — the premiums are juicier. OptionsPilot's screener highlights annualized premium yields so you can compare opportunities across different stocks and expirations on an apples-to-apples basis.