Premium = Intrinsic Value + Time Value; contract cost = quoted premium x shares per contract
What it is
An option premium is the market price of an option contract. The buyer pays it up front to the writer (the seller), who receives the cash and takes on an obligation in return. It is quoted per share, so the cash amount is the quoted premium multiplied by the number of shares the contract covers. Standard North American equity contracts cover 100 shares, so a premium quoted at 2.40 would cost 240 dollars per contract before commissions (an arithmetic illustration, not a typical price). The premium is set by supply and demand in the options market, the same way a stock price is. It is not calculated by the exchange and handed to the market.
Why it matters
The premium defines the money at stake, and the stakes are asymmetric. A buyer's maximum loss is the premium paid: if the option expires worthless, that entire amount is gone, a total loss. A writer's position is the mirror image. The premium received is the most the written option itself can earn, while the loss side can run far past it. An uncovered (naked) call writer faces theoretically unlimited loss, because there is no ceiling on how far the underlying can rise. A put writer's loss is bounded only by the underlying falling to zero, which can still dwarf the premium collected. Premium received is never free income; it is compensation for accepting an obligation. A large premium is also not a verdict on value: it can reflect intrinsic value, time remaining, expected volatility, or any mix of the three.
How it's calculated
The premium is observed, not computed: it is whatever price buyers and sellers agree on, published by the exchange as a bid, an ask, and a last trade. Analysts split it in two. Intrinsic value is how far the option is in the money now: for a call, underlying price minus strike; for a put, strike minus underlying price; never below zero. Time value is the rest, reflecting time left plus expected volatility. It erodes as expiry approaches (theta decay), and that erosion accelerates rather than running at a steady rate. Implied volatility is not an input to this price: it is the figure found by inverting a model such as Black-Scholes until its output matches the observed premium.
Cross-border note. Conventions are broadly similar: standard equity options on US exchanges and on the Montreal Exchange (which lists Canadian equity and index options) typically cover 100 shares. But premiums are quoted per share in the listing currency, US dollars or Canadian dollars respectively, so an identical quoted number represents a different amount of money depending on where the contract is listed.
FAQ
If I buy an option and it expires worthless, do I lose only the premium?
Yes, and that word 'only' hides a lot. For an option buyer, the premium paid is the maximum loss, so there is no further obligation and no margin call. But the option simply lapses and the buyer loses 100 percent of what was paid. The premium is fully at risk, not a deposit that is partly refundable, and expiring worthless is an ordinary outcome for an option that finishes out of the money, not a freak one.
Why is one option's premium so much bigger than another's on the same stock?
Three main reasons. First, intrinsic value: an option already deep in the money carries value from the gap between the underlying price and the strike. Second, time: more days until expiry means more time value. Third, expected volatility: when the market expects large moves, premiums rise across the board. A high premium is not evidence that an option is overpriced, and a low one is not evidence of a bargain. Each reflects what the market currently expects.
The writer keeps the premium no matter what, so is writing options a way to collect income?
The premium is kept, but that is only one side of the ledger. In exchange, the writer takes on an obligation that can cost far more than the premium collected. An uncovered call writer's loss is theoretically unlimited. A put writer can be obligated to buy shares well above market value. Even a covered call writer gives up gains above the strike. The premium is payment for bearing that risk, and calling it income ignores the obligation attached to it.