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Understanding Option Premiums for Income

Option Premiums

The premium is the price paid or received for an option. Options are traded much like stocks, with bid and ask prices shown:

  • Seller generally receives the bid price
  • Buyer generally pays the asked price

 

  • Market maker makes or specialist keeps the spread between the bid and ask prices.

An example: A stock is trading at $40, and the October Call prices are quoted as follows:

BID = $1.70 ASK = $1.80

This means the high bidder will pay $1.70 and the lowest price offered to the buyer is $1.80. Note the $0.10 spread between the two prices. Actually, the only time the seller can be assured of getting the bid price, or the buyer only the asked price, is to enter a trade order as a market order, at which they get the market price at the time the order is executed. Market makers have to execute a market order at market price, up to the number of contracts for which the bid or offer is good, but are not obligated to take limit orders. By using the limit order, the seller might get the $1.75 or $1.80 for writing the call. And the buyer can enter a limit order for less than $1.80 such as $1.70 in an attempt to buy the call at a cheaper price.

Historically, the premium referred to the total amount received for selling the contract, not to the option price. Today the term “premium” simply means the options price on a per share basis. That is, the premium shown is bid at $1.70 that means $1.70 per share; you would expect to receive $170 ($1.70 X 100) for an entire option contract related to 100 shares. The premium can be all intrinsic value, all time value or contain both.

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