What is Premium in Futures and Options?

In this article, we will discuss

• Components of Options Premium
• Formula for Calculating Option Premium
• Factors Affecting Options Premium
• Difference Between Futures and Options
• Differences in trading and settlement
• Premium calculation for futures and options

In futures and options trading, the term "premium" refers to the price that traders pay for the right to purchase or sell an underlying asset at a predetermined price, known as the strike price. The premium is a crucial concept in these financial instruments because it represents the cost of entering into a position and therefore directly affects the potential profitability of the trade. It is crucial to first understand the fundamentals of futures and options trading in order to comprehend the premium. Options provide the buyer the right, but not the responsibility, to sell or buy the asset at a set price and time, whereas futures are contracts that bind the buyer to acquire an underlying asset at a specific price and time in the future. In both situations, traders must pay a premium to enter the contract, which stands in for the trade's potential gain or loss.    Options trading strategies successfully require an understanding of the premium. Traders must take the premium into account when calculating whether a transaction is profitable because it is the cost of taking a position.They must also keep a careful eye on the premium because it might change depending on the state of the market and other variables, such as shifts in interest rates or geopolitical events.

Components of Options Premium

The price an option buyer pays an option seller in exchange for the right, but not the duty, to purchase or sell an underlying asset at a defined price and time is known as the options premium. The price of an option is influenced by a number of variables, including the underlying asset's current value, the amount of time left before it expires, and the projected volatility of its price. The intrinsic value, time value, and volatility value are the three basic parts that make up the option premium.

• Intrinsic Value

Intrinsic value is the difference between the current market price of the underlying asset and the strike price of the option. For call options trading strategies, the intrinsic value is the difference between the current market price of the underlying asset and the strike price of the call option. For put options, the intrinsic value is the difference between the strike price of the put option and the current market price of the underlying asset. Intrinsic value is the minimum value of an option, as it represents the value that the option would have if it were to expire immediately. In other words, if an option has intrinsic value, it means that the option is already in-the-money. This means that if the option were to expire immediately, it would be profitable to exercise the option. The value of the underlying asset is the most significant factor affecting the intrinsic value of an option. If the underlying asset's price increases, the intrinsic value of a call option increases, while the intrinsic value of a put option decreases. Conversely, if the underlying asset's price decreases, the intrinsic value of a call option decreases, while the intrinsic value of a put option increases.

• Time Value

Time value is the amount of the option premium that is attributed to the time remaining until expiration. Time value represents the value of the option that is not attributable to intrinsic value. It is the value that the option has because of the possibility that the underlying asset's price will move in a favorable direction before the option's expiration. Time value is affected by several factors, such as the volatility of the underlying asset, interest rates, and dividends. An option's time value can also be affected by events that may affect the price of the underlying asset, such as earnings reports or news events. The amount of time remaining until the option's expiration date is the most significant factor affecting time value. As the expiration date approaches, the time value of an option decreases, as there is less time for the underlying asset's price to move in a favorable direction.

• Volatility Value

Volatility value is the amount of the option premium that is attributed to the expected volatility of the underlying asset's price. Options on highly volatile assets will have a higher volatility value than options on less volatile assets. This is because there is a greater chance that the price of a highly volatile asset will move significantly before the option's expiration date, making the option more valuable. Volatility value is affected by several factors, such as the historical volatility of the underlying asset's price, the expected volatility of the underlying asset's price, and the time remaining until the option's expiration date. The implied volatility of an option is an estimate of the expected volatility of the underlying asset's price and is calculated based on the current market price of the option. Options on stocks that are expected to have high volatility in the future will have a higher implied volatility than options on stocks that are expected to have low volatility in the future. Similarly, options with longer time remaining until expiration will have a higher implied volatility than options with shorter time remaining until expiration.

Formula for Calculating Option Premium

The formula for calculating option premium takes into account the three main components of an option's price: intrinsic value, time value, and volatility value. The basic formula for calculating the price of an option is: Option Premium = Intrinsic Value + Time Value + Volatility Value The intrinsic value is calculated by subtracting the strike price from the current market price of the underlying asset. The time value and volatility value are more complex to calculate and are usually estimated using options pricing models such as the Black-Scholes model.

Factors Affecting Options Premium

• Price volatility of the underlying asset

Price volatility is a measure of the magnitude and frequency of price changes in the underlying asset. Higher volatility leads to a higher option premium because it increases the likelihood that the underlying asset's price will move significantly before the option expires, giving the option holder a greater chance of making a profit. Conversely, lower volatility leads to a lower option premium because it reduces the likelihood of significant price movements, making it less likely that the option holder will make a profit. Options that are based on highly volatile assets, such as technology stocks, tend to have higher premiums than options based on less volatile assets, such as utility stocks. This is because the potential for larger price swings in the underlying asset means that there is a greater chance of the option being profitable.

• Time to expiration

The premium of an option is also influenced by the length of time left until its expiration date. Because they give the option holder more opportunity to turn a profit, options with longer expiration dates typically have greater premiums than options with shorter expiration periods. The time value of the option drops as the expiration date draws near, lowering the premium. For example, if an investor purchases a call option with an expiration date that is several months away, they have more time to wait for the underlying asset's price to increase before the option expires. This longer time frame means that the option has a higher chance of being profitable, so the premium will be higher than if the same option had an expiration date only a few weeks away.

• Interest rates

Higher interest rates lead to higher premiums for call options and lower premiums for put options because they increase the opportunity cost of holding the underlying asset. This means that the option holder would be better off buying the asset outright and earning the higher interest rate instead of holding the option. Conversely, lower interest rates lead to lower premiums for call options trading strategies and higher premiums for put options trading strategies because the opportunity cost of holding the underlying asset is lower, making it more attractive to hold the option instead.

• Dividend payments

A firm pays its shareholders dividends, which are cash payments. A company's stock loses value by the dividend amount when it pays a dividend, and vice versa. The premium of options based on that stock may be impacted by this decline in stock price. For example, if an investor holds a call option trading strategy  on a stock that pays a dividend, the stock's price will decrease by the amount of the dividend on the ex-dividend date. This decrease in price reduces the option's intrinsic value, which is the difference between the current stock price and the strike price. As a result, the premium of the call option will decrease. On the other hand, if an investor holds a put option trading strategy on a stock that pays a dividend, the decrease in stock price can increase the option's intrinsic value, leading to an increase in the put option's premium.

Difference Between Futures and Options

Futures and options are two popular financial derivatives that offer investors opportunities to speculate on price movements and manage risk. While both futures and options have similarities, such as the ability to trade on exchanges and the use of underlying assets, they differ in several important ways as follows:

• Definition of futures and options

Futures contracts are arrangements to purchase or sell the underlying asset at a predetermined price and future date. Commodities, currencies, stocks, or bonds are all examples of potential underlying assets. A futures contract's buyer and seller are both required to purchase the underlying asset at the agreed-upon price on the contract's expiration date. Futures contracts have specified terms, are exchanged on exchanges, and the exchange regulates the contracts' terms. In contrast, options allow the buyer the choice—but not the obligation—to purchase or sell the underlying asset at a particular price and time in the future. Options, like futures, can have a variety of underlying assets as their foundation. Options contracts are negotiated between the buyer and seller and can be traded on exchanges or over-the-counter (OTC).

Differences in trading and settlement

The way that futures and options are traded and settled is different. Exchanges like the Chicago Mercantile Exchange (CME) or the New York Mercantile Exchange are where futures contracts are transacted. (NYMEX). Futures contracts are standardized, and the exchange determines the contract's terms, such as the contract's size and its expiration date. Futures contracts are daily settled, which means that at the conclusion of each trading day, the profits or losses from the contract are computed and settled in cash. Options can be traded on exchanges or OTC. Unlike futures, options are not standardized, and the terms of the contract are negotiated between the buyer and seller. Options contracts have a fixed expiration date, after which the contract becomes worthless. The settlement of an options contract depends on whether it is exercised or not. If the option is exercised, the buyer can buy or sell the underlying asset at the agreed-upon price. If the option is not exercised, it expires worthless.

Premium calculation for futures and options

The premium for a futures contract is determined by the market price of the underlying asset, the size of the contract, and the expiration date. The premium is paid upfront when the contract is purchased, and the amount of the premium varies depending on the current market conditions. Futures contracts do not have a strike price like options, so the premium is based on the current market price of the underlying asset. The premium for an options contract is based on several factors, including the current market price of the underlying asset, the strike price, the time remaining until expiration, and the volatility of the underlying asset's price. The premium for an option is the price paid by the buyer to the seller for the right to buy or sell the underlying asset at the agreed-upon price. Options premiums can be significantly higher than futures premiums due to the added flexibility and risk management features offered by options.

Conclusion

Premium  is a critical component of futures and options trading that investors must understand to make informed investment decisions. The premium represents the cost of the derivative contract and is influenced by several factors, such as the underlying asset's price volatility, time to expiration, interest rates, and dividend payments. Understanding how premium is calculated and its role in trading is crucial for investors looking to manage risk and profit from price movements. To help investors navigate the world of futures and options trading and choose the right options trading strategies the Samco app offers a comprehensive trading platform with a range of educational resources and tools. Samco's platform provides users with access to live market data, research reports, and expert insights to help make informed investment decisions. Additionally, the app's user-friendly interface and advanced trading tools, such as options calculators and real-time market scanners, make it easier for investors to manage their portfolios and execute trades with confidence.