Premium in Derivatives

What is Premium in Derivatives Options? A Comprehensive Guide

In the derivatives (futures & options) market, you pay a certain price to enter into the contracts. This price is better known as a premium in the option market that keeps fluctuating as per the market movement or you can say as per the change in the price of the underlying security.

Premium in option playing a key role in determining the contract value, and based on the price of the premium option, traders calculate their potential profits, losses and overall trade value. Hence, understanding the premium is very important to trade in the option market more efficiently.

Here we are going to discuss about premium in option, how they work and how they are calculated with the various factors affecting the premium and how to use it in option trading.

What is Premium in Options?

Option premium in the derivatives market is the price of an option (Call or Put) contract of an underlying security paid for the strike price. When you buy an option, you have to pay a price called a premium that represents the current market price of the contract for a particular strike price.

In fact, a premium is the price you pay to freeze your buying or selling price in future, whatever the price of the underlying security trading at that time. The premium keeps fluctuating as per the movement in the market or a change in the price of the underlying security.

How is Premium Calculated in Options?

Option premium is calculated on the basis of taking the sum total of both (intrinsic value and time value). Though, as per the movement in the market and change in the original price of the underlying security, the option premium keeps changing. Apart from this, there are also various factors that affect the option premium.

Option Premium Calculation Formula & Example

Option Premium = Intrinsic Value + Time Value

• Intrinsic Value:It is the tangible value of the option considered if the contract is exercised immediately. In a call option, it shows the difference between the current market price of the underlying security and the strike price of the derivative contract. While in a put option, it shows the difference between the strike price and the current price of the underlying.

• Time Value: It is also called the extrinsic value, an amount paid by the option buyer for the potential of a change in the stock price as per his expectations before the contract expiration. However, due to time decay (Theta), this time value keeps decreasing as soon as the expiration date arrives.

Option Premium Calculation Example

Suppose the current market price of an underlying security is Rs 1,500, and you entered into an option contract of a strike price of Rs 1,400; here, the time value is Rs 50.

Intrinsic Value: 1500 (CMP) – 1400 (strike price) = 100

Option Premium: 100 (Intrinsic value) + 50 (time value) = 150 per share.

It means you are paying Rs 150 as an option premium, in which Rs 100 is the intrinsic value and Rs 50 is the time value of the underlying security.

Factors Affecting Premium in Options

The demand and supply of the underlying security are the prime factor that affects the price of the option premium. Let’s find out the other factors affecting premiums in options.

• Spot Price of Underlying Security: When the spot price of the underlying security changes, the premium of the option also changes as per the upside or downside movement.

• Strike Price: Options near the current stock price have a higher premium, as there are higher chances of the option ending in the money. While the option far away from the current market price would be cheaper, it would take more time and larger movements to reach there.

• Expiration Time: The time of expiration of the option contract is one of the major factors that determines the premium of the option. Near the option’s expiration date, the time value erodes quickly, bringing the option premium down. The longer the expiration dates, the higher the premium, which enables more time to move in favour of the price of the underlying security.

• Implied Volatility (VIX): Volatility is another factor that drives the option premium price. The higher the volatility, the higher the swing in the price, making the price of the underlying security volatile. High volatility can increase or decrease the premium even if the stock price remains the same.

• Interest Rates: The higher the interest rates, the more the option premium would be, also slightly costlier. Though in the case of a call option, high rates push the price up, while in the case of a put option, they make the option premium more affordable.

• Dividend Pay-outs: Dividends declared by a company have an impact on the price of the underlying security, which also influences the option premium price of the underlying. However, the smaller amounts of dividends don’t have a significant impact on the price of the underlying.

How to Choose Premium in Option Trading?

Choosing the right premium in options can have a significant impact on your trading strategy. Though you cannot decide to choose the premium as per your desired levels, instead, you have to pick the right strike price with the premium that you can afford to pay. Let’s find out how different strike prices have different option premium values.

• In-the-Money (ITM): An option contract with ITM strike price has a higher premium due to high intrinsic value and lower time value. However, such a premium has less impact from time decay but needs a higher amount of capital to enter into the trades.

• At-the-Money (ATM):Balanced premium price consists mainly of the time value. The option with an ATM strike price is suitable for the sideways market movement trades.

• Out-of-the-Money (OTM):The option with an OTM strike price has a low premium as it has pure time value. However, such OTM options have higher chances of expiring worthless but can give high returns if the underlying security moves strongly.

• Expiration Time: Apart from choosing the right strike price, always avoid buying the option close to expiry, as there is rapid time decay eroding the option premium value.

• Implied Volatility: And last but not the least, before you choose any strike price and pay option premium, always check the volatility of the underlying. During high volatility, the premium is high; it would be better to sell the option and collect the premium. While in low volatility, the premium is low, you should buy the option premium and expect the volatility to increase.

How to Use Premium in an Option Trading Strategy?

Understanding the option premium is not enough; you need to use it in the option trading strategy to improve the chances of success of your trade positions. Below you can find a few option strategies that you can follow while considering the premium.

• Buy Options: When you expect the market or underlying security to move in a particular direction, you can trade with a long position in options to get returns with limited loss. You can buy a call option if you think the price of the underlying security will rise, and you can buy a put option if you expect the price of the underlying to fall before the expiry.

• Sell Options: This writing of an options strategy comes with the risk of unlimited loss when the market moves against your expectations. However, if the market or underlying security remains neutral or moves as per your expectation, you will earn the premium you collected from option selling.

Wrapping-up

Premium in options is the price that option buyers and sellers consider when entering into a trade position. The option premium can vary for different strike prices of the same underlying security. Option premium consists of intrinsic value and time value that keeps fluctuating as per the movement in the market or price of the underlying security.

However, strike price, implied volatility and date of expiration are the major factors that influence the option premium price. But, you can use the ITM, OTM or ATM options to choose the right premium that you can afford and also suits your option trading strategy.