Option premium — what is it?

  Options are a type of security whose holder has the right to buy or sell the underlying asset at a fixed price within an agreed period. The holder is not obliged to perform the agreed action and may choose whether to exercise the option or not. The seller, on the contrary, bears an obligation that cannot be refused. Nevertheless, contrary to what it may seem at first glance, such a contract is beneficial for both parties, regardless of the disproportionate distribution of rights and obligations, since in addition to these two aspects of relations, there is also such a concept as the option premium. To better understand this, it is worth examining the question: what is an option premium?

 

General concept of an option premium 

  If we consider only exchange-traded and over-the-counter options, we can form the following definition: an option premium is the amount that the seller receives from the buyer. The option price and its premium are identical concepts.
  Working with options is associated with constant risk of financial losses. By assuming certain obligations, the seller requests a one-time fixed payment in return. Upon expiration, he may either remain in profit by receiving his legitimate premium or suffer financial losses.
  Options have recently become a very popular trading instrument. It is precisely the opportunity to earn from premiums that supports a constant number of offers to sell options. Demand for such securities will always exist and does not need special stimulation, since with proper investment, an investor can obtain quick profit or insure investments in other assets.
  Let us consider an example. There is such a concept as a call option. It gives its holder the right to buy an asset in the future at the price agreed at the time. The seller undertakes to sell the underlying asset to the buyer at a fixed price, regardless of what the market price will be at the time of sale.

  For example, in January, an option contract is concluded between two parties, under which the seller undertakes to sell an asset at the current market price, say, 1,000 rubles. The contract is valid until the end of March, and for concluding it, the seller receives a premium of 100 rubles. Now let us see why such a deal is beneficial for the buyer. He can make quick profit if the asset price rises sharply. Suppose in February the asset rises to 1,500 rubles. The investor, using his option, buys the asset for 1,000 rubles and sells it at the current price, resulting in a profit of 500 rubles minus 100 rubles (option premium). The option seller incurs a loss of 400 rubles, since he has to compensate the difference between the agreed and market price at his own expense, that is, 500 rubles minus the premium. If the holder had not exercised his right, the seller would have kept the premium.
  As you can see, the seller assumes the risk for which he receives the premium. We believe the question “what is an option premium?” has now been fully answered.

 

Calculation of the option premium 

  As options gained popularity, the issue of pricing began to arise. Previously, the price depended only on the seller, who could significantly increase the premium without proper justification, making the security unattractive to buyers. There was always the question of creating a universal pricing model.
  In the early days of options, before the formation of global exchanges, the idea of an efficient market was applied. It implied that the option price was formed in such a way that, on average, neither the buyer nor the seller made a profit. This model is effective only for commodity options, which in some ways resemble a company’s initial shares.
  For example, an entrepreneur decides to open a store. He has premises, equipment, and suppliers, but lacks initial capital. He issues a package of options. Those who buy them gain the right, after the store opens, to receive goods at a price below the current market average. Moreover, the option holder benefits even after accounting for the premium paid. Naturally, buyers are interested in such an offer, and all the securities are quickly sold. As a result, the entrepreneur raises the required amount and successfully opens the store. Soon, all securities are exchanged for goods at a discount. In the end, the buyer purchases goods at an acceptable price, and the seller incurs minor losses but gains funds to open the store and acquire first customers. On average, both buyer and seller gain some benefit while also gaining nothing. This is the main idea of an efficient market.

  Under exchange conditions, this pricing method is no longer relevant, since both buyer and seller enter into transactions to earn large profits. Each party strives to gain everything or nothing. Mutually beneficial pricing no longer works, but again, the seller cannot raise premiums excessively, since he would simply fail to find interested buyers.
  Recently, calculating premiums based on the average value of the underlying asset has become popular. The average asset value is determined taking into account market conditions, exchange rates, and the overall economic situation in the country and the world. Option premiums average 8–10% of the calculated asset value. The longer the option term, the higher the percentage taken, since the seller’s risk increases with time.

 

Premium in binary options

  There is a subtype of options in which the concept of premium differs significantly. These are called binary options and are quite far from the traditional understanding of securities. The holder can exercise the option only if a certain condition is met. Binary options are essentially exchange-based games in which a trader bets on whether an asset’s price will rise or fall in the near future.
  In this case, the option premium is the income that a trader can receive as a result of a successful forecast. The player knows the possible premium in advance. As a rule, exchanges indicate potential winnings as a percentage of the investment amount, usually 60–85%.
  One should not confuse the concepts of premium and profit. Profit is the premium minus the investment. For example, a trader makes a successful $100 investment and receives $160, which is the premium. However, this does not reflect the investor’s profit, since he spent $100 to buy the option, meaning his profit is $60.
  This concept of premium in binary options applies only to buyers and successful outcomes. If the investment is unsuccessful, the entire amount goes to the broker and becomes his premium. Thus, if in the example above the forecast had been wrong, the seller would have received $100 as a premium.