Premium

The Premium is the price that an options buyer pays to the options seller (also known as the writer) for the right granted by the option contract. The premium is determined by several factors, including the underlying asset’s price, strike price, time until expiration, and market volatility. It is paid upfront by the buyer to the seller and is non-refundable, regardless of whether the option is exercised.

Key Features:

Price of the Option: The premium is the cost of purchasing an options contract and represents the price the buyer pays for the right to buy (call option) or sell (put option) the underlying asset at the specified strike price before the expiration date.

Components of the Premium:

• Intrinsic Value: The value of the option if it were exercised immediately. For call options, this is the difference between the stock’s current market price and the strike price (if the stock price is above the strike price). For put options, it’s the difference between the strike price and the market price (if the stock price is below the strike price).

• Time Value: The amount of the premium attributed to the time left until the option expires. The longer the time to expiration, the higher the time value, as there is more potential for the option to become profitable.

• Implied Volatility: The market’s expectations of the asset’s future volatility. Higher volatility generally increases the premium because it increases the chances of the option becoming profitable before expiration.

• Interest Rates and Dividends: In some cases, the level of interest rates and the underlying asset's dividend payments can influence the option's premium.

Payment: The premium is paid upfront by the buyer when the option contract is purchased. Once paid, it is not refundable, even if the option is not exercised or expires worthless.

Seller's Profit: For the seller (or writer) of the option, the premium is received as income, and it represents the maximum potential profit from the option contract.

Importance of Premium:

Cost of Entering an Options Position: The premium is the primary cost for an options buyer. It must be factored into any potential profit or loss calculation for the options trade.

Profitability Calculation: The premium is subtracted from any potential gains made from exercising the option. For a call option to be profitable, the underlying asset’s price must exceed the strike price by more than the premium paid. For a put option to be profitable, the underlying asset’s price must fall below the strike price by more than the premium paid.

Risk for the Buyer: The total amount that an options buyer stands to lose is limited to the premium paid for the option. If the option expires worthless or is out-of-the-money, the buyer loses the entire premium.

Income for the Seller: The seller of an option receives the premium as income, but they assume the risk of having to fulfill the terms of the contract if the option is exercised by the buyer.

Top 10 FAQs:

How is the premium of an option determined?
The premium is determined by a combination of factors, including the intrinsic value of the option (the difference between the strike price and the market price of the underlying asset), the time to expiration, implied volatility, interest rates, and dividends.

What happens to the premium if the underlying asset’s price changes?
The premium can fluctuate as the underlying asset’s price changes. For call options, an increase in the asset's price generally increases the premium. For put options, a decrease in the asset's price generally increases the premium.

Is the premium refundable?
No, the premium is not refundable. Once the buyer pays the premium, it is the cost for acquiring the option, regardless of whether the option is exercised, sold, or expires worthless.

Can an option have a negative premium?
No, an option cannot have a negative premium. The premium represents the price paid for the option and cannot fall below zero.

How does implied volatility affect the premium?
Higher implied volatility generally increases the premium, as it increases the likelihood that the option will become profitable before expiration. Options with high volatility are perceived to have a greater potential for price movement, which increases their value.

What is the relationship between the strike price and the premium?
The strike price impacts the intrinsic value of the option, which in turn affects the premium. For call options, the closer the strike price is to the underlying asset’s market price, the higher the premium. For put options, the closer the strike price is to the market price, the higher the premium.

Example:

Suppose you buy a call option for stock XYZ with a strike price of $100, and the premium for the option is $5. This means you pay $5 per share to have the right to buy stock XYZ at $100 per share, regardless of its market price. If the stock rises to $110, you can exercise the option, buying it for $100 and selling it at $110, making a $10 profit per share. However, you must subtract the $5 premium you paid, so your net profit would be $5 per share.