Stock Market · Options Theory

How premium is priced

Option premiums are not arbitrary. They're determined by a set of factors that professional traders, market makers, and pricing models all evaluate simultaneously.

The six factors that drive premium

1. Underlying price: the current spot price relative to the strike. More ITM = higher premium.

2. Strike price: distance from current price. Further OTM = cheaper premium.

3. Time to expiry: more time remaining = higher premium. Time value decays as expiry approaches.

4. Volatility (Implied Volatility): MOST important variable that changes continuously. Higher IV = higher premium for all options. IV is the market's expectation of future price swings.

5. Risk-free interest rate: small effect. Higher rates = slightly higher call premiums, lower put premiums.

6. Dividends: upcoming dividend payments affect futures price (and thus option pricing).

> Two identical call options (same strike, same expiry) can have very different premiums on different days. Purely because IV changed.

Practical implication

Before a major event (RBI policy, election results, quarterly earnings), IV rises, premiums inflate. Immediately after the event (regardless of direction), IV crashes, premiums collapse. This is called 'IV crush.'

IV crushoption buyers often lose money even when they predicted direction correctly, because the premium collapses after the event

How market makers price options

They use models (Black-Scholes for vanilla options) that take all six factors and compute a fair premium. Then they continuously hedge their delta exposure. The spread between bid and ask is their profit.

Understanding these factors helps you decide: is the premium fair? Are you buying expensive volatility before an event? Are you selling premium when IV is low?

Takeaway. Option premium = a function of spot price, strike, time, implied volatility, rates and dividends. IV is the most dynamic input, and it inflates ahead of known events, so buying then means paying for volatility the market has already priced in, and watching it drain out once the event passes.