Option Premium
Definition
Option premium is the total price you pay to buy an options contract, composed of two parts: intrinsic value (the amount the option is already in the money) and extrinsic value (time value plus implied volatility premium that exists purely because the option hasn't expired yet).
Example
“I paid $3.20 in premium for a call with the stock at $47 and a $45 strike — $2.00 was intrinsic (the option was $2 in the money) and $1.20 was extrinsic. That $1.20 would decay to zero by expiration regardless of what the stock did.”
Detailed Explanation
Understanding what you're paying for when you buy an option is fundamental. The intrinsic value portion is real and immediate — if you exercised the option right now, this is what you'd capture. A call with a $45 strike when the stock trades at $47 has $2 of intrinsic value. The extrinsic value (also called "time value") is the premium above intrinsic that exists because of time remaining and implied volatility. This is the portion that works against you every single day as an option buyer — theta (time decay) is steadily eroding the extrinsic value whether the stock moves or not.
For out-of-the-money options, the entire premium is extrinsic — there is no intrinsic value at all. You're paying purely for the right to benefit IF the stock moves to the strike price and beyond before expiration. OTM options are cheaper in absolute terms but have a lower probability of expiring in the money, and the entire premium is at risk of going to zero. This is why buying cheap OTM options as lottery tickets is a losing strategy over time — you need not just a directional move, but a sufficient magnitude move, within a specific time window, while also overcoming the constant drag of time decay and potential IV compression.
When you sell options, you're on the other side of this equation — you're the one collecting the premium, and theta is working in your favor. Every day an option doesn't reach its strike price, the extrinsic value erodes and the position gains value (for the seller). This is why premium selling strategies are popular: they profit from time passing, which happens every day, not just when a specific directional thesis plays out. The risk is that a large adverse move can quickly overwhelm the collected premium. Understanding the full premium structure — what you're buying or selling — is non-negotiable before sizing up in options.