Strike price, expiration date and premium

Three numbers describe an option on a given stock: the price at which it can be exercised, the day it ends, and what it costs. The first two are terms of the contract. The third is set by the market and changes all day.

What the strike price of an option is

The strike price is the price per share at which the holder of a call may buy the shares and the holder of a put may sell them. It is a term of the contract. The price of the stock moves every day and the strike price stays where it is.

The exchanges list many strike prices for each expiration date, above and below the price of the stock. They are spaced at intervals of $0.50, $1, $2.50, $5 or $10, depending on the price of the stock. The strike price decides how far the stock has to move before the option is worth exercising: a 55 call on a $50 stock needs a rise of more than $5, and a 45 call is already $5 in the money.

What the expiration date of an option is

The expiration date is the last day on which the option exists. A standard monthly option expires on the third Friday of its month, and at least four expiration months are listed on a stock at any time. Weekly options expire on the Fridays in between, and LEAPS are long-term options that expire up to two years and eight months away.

An option can be traded until the market closes on its expiration date. If that day is an exchange holiday, the last trading day is one day earlier. After that the contract is over. An option that is in the money by $0.01 or more at expiration is exercised unless its holder instructs otherwise, and an option that is out of the money expires worthless.

What the premium of an option is

The premium is the price of the option. It is quoted per share, and one standard contract covers 100 shares. A premium of $1.80 means $180 for one contract.

The buyer pays the premium up front and the writer receives it. It is no down payment on the shares and it is not refunded. A buyer who lets the option expire does not get it back, and a writer who is assigned keeps it.

A premium has two parts. Intrinsic value is the amount by which the option is in the money. Time value is the rest: what the market pays for the time left and for the movement it expects. Moneyness, intrinsic value and time value takes the two parts apart.

How the strike price and the expiration date change the premium

The table shows premiums for a stock at $50, computed with the Black-Scholes model from a volatility of 30%, an interest rate of 4% and no dividend. Market premiums differ from model values.

Two patterns hold in every row and column. A call costs more the lower its strike price, and a put costs more the higher its strike price, because the right is worth more. Every option costs more with 90 days left than with 30, because more can happen in 90 days.

Example of two calls on the same stock

The option with the lower premium is not the cheaper one in every sense. It costs less because the stock has to move further before it is worth anything.

What can go wrong with the strike price and the expiration date

A holder can be right about the stock and still lose the premium. If the stock reaches the strike price after the expiration date, the option has already expired worthless. If the stock ends between the strike price and the break-even, the option has some value and the position still shows a loss.

An option with little time left loses its time value fast, and an option far out of the money is made of time value only. A low premium often goes with a small chance that the option is worth anything at expiration.

Time is a cost for the holder of an option. Every day that passes without the move the holder needs leaves less time for it to happen.