Premium is the price that a trader buys or sells an options contract for. It is determined by a variety of factors, including:

-- The intrinsic value of the option. When an option is in the money, the intrinsic value is the difference between the market price of the underlying security and the option's strike price. When an option is out of the money, the intrinsic value is \$0.

-- The time value of the option. Time value decreases as the expiration date nears because there is less time for the intrinsic value to increase. Time value reaches \$0 on the option's expiration date.

-- The implied volatility of the option. The portion of the premium associated with the implied volatility will increase as the volatility of the underlying security increases, because the chance of reaching the strike price is higher for more volatile securities.

There are several formulas that are used to determine what the premium of an option should be. The Black-Scholes formula is among the best known, and its importance has been recognized with a Nobel Prize in Economics.

In the most simplified terms, the premium can be found with an equation that considers several factors:

Premium = Intrinsic Value + Time Value + Implied Volatility

To find the intrinsic value of the option, find the difference between the market price of the underlying security and the option's strike price. For a call option, subtract the strike price from the current market price of the underlying security. For example, a call with a strike price of \$10 on a stock with a market price of \$15 has \$5 of intrinsic value. For a put option, subtract the market price of the underlying security from the strike price. A put with a \$12 strike price on a stock with a market price of \$9 has \$3 of intrinsic value. Again, the intrinsic value for out-of-the-money options is \$0.

Determining the time value and implied volatility is more difficult. There are a number of calculators available on different websites and in software packages that can do this.