How Is the Premium of an Option Determined?

An option's premium, the price paid by the buyer to the seller, is determined by two main components: intrinsic value and extrinsic (time) value. Intrinsic value is the immediate profit from exercising the option.

Extrinsic value is based on factors like time to expiration, volatility, interest rates, and dividends. These components are mathematically modeled, most famously by the Black-Scholes model.