Premium
Premium is the total amount of money (price) you pay for an option. So, if
the Microsoft (MSFT) May 65 calls cost you $1.50 then the $1.50 is the amount of
the premium of the option.
The total price of an option (premium) consists of two components. Those two
components are intrinsic value and extrinsic value.
Intrinsic value, also called parity, is the amount by which an option is in
the money. In the case of a call, the intrinsic value is equal to the present
stock price minus the strike price. In the case of a put, the intrinsic value is
equal to the strike price minus the present stock price. Only in-the-money
options have intrinsic value. Out-of-the-money options have no intrinsic
value.
For example, with MSFT trading at $65.00, the MSFT January 60 calls will have
$5.00 of intrinsic value. If the MSFT January 60 calls were trading at $5.70,
then $5.00 of that premium would be intrinsic value.
At the same time, the MSFT January 70 put will also have $5.00 of intrinsic
value. So, if the MSFT January 70 puts were trading for $5.70, then $5.00 of
that premium would be intrinsic value.
Extrinsic value is defined as the price of an option less its intrinsic
value. In the case of out-of-the-money options, the option's entire price
consists only of extrinsic value. Extrinsic value is made up of several
components, with the largest being volatility.
In the examples above, if the MSFT January 60 calls were trading at $5.70 and
$5.00 of that was intrinsic value, then the remainder ($.70) is extrinsic value.
The same also holds true for the January 70 puts. If they were trading at $5.70
and $5.00 of that was intrinsic value, then the rest ($.70) is extrinsic
value.
Parity
Parity - When we discuss parity in terms of options, we say that parity is
the amount by which an option is in the money. Parity refers to the option
trading in unison with the stock. This also means that parity and intrinsic
value are closely related. When we say that an option is trading at parity, we
mean that the option's premium consists of only its intrinsic value.
For example, if Microsoft was trading at $53.00 and the January 50 calls were
trading at $3.00, then the January 50 calls are said to be trading at parity.
Under the same guidelines, the January 45 call would be trading at parity if
they were trading at $8.00. So, parity for the January 50 calls is $3.00 while
parity for the January 45 calls is $8.00
Now if these calls were trading for more than parity, the amount (in dollars)
over parity is called ‘premium over parity.' Thus, the term ‘premium over
parity' is synonymous with extrinsic value, which was discussed above.
If the stock is trading at $53.00 and the January 50 calls are trading at
$3.50 then we would say that the calls are trading at $0.50 over parity. The
$0.50 represents the premium over parity that is also the amount of extrinsic
value. The $3.00 is the amount of intrinsic value or parity.
The term time decay is defined as the rate by which an options extrinsic
value decays over the life of the contract.
