New traders must grasp option premium. Option premiums affect options trading profitability. This beginner’s tutorial will explain option premiums, their calculation, and their importance.
Definition of Option Premium
Option premium is the amount a buyer pays a seller to acquire or sell an underlying asset at a given price and time. This is the cost of holding an option contract. The current asset price, strike price, period till expiry, volatility, and market circumstances affect the premium.
Calculating Option Premiums
Most option premiums are calculated by complicated mathematical models like Black-Scholes. This model considers volatility, interest rates, period till expiry, strike price, and underlying asset price.
The computation of option premiums might be complicated, but beginners should grasp the elements that affect them. Important aspects include:
Option premium depends on the underlying asset price. Call option premiums climb as the price rises, whereas put option premiums fall.
Volatility: Increasing volatility raises uncertainty and option premium.
Time till Expiration: The option’s premium rises as the underlying asset’s price has more time to move in the desired direction.
The strike price is the price at which the asset may be purchased or sold. The premium depends on the strike price-market price gap.
Higher interest rates usually increase option premiums.
The Value of Option Premiums
Traders must understand option premiums since they reflect the cost and possible profit or loss of an options transaction. The premium impacts trade breakeven, profitability, and risk. By considering the premium, traders may evaluate risk-reward and make educated trading choices.
A high option premium indicates that the market anticipates large price swings or increased uncertainty in the underlying asset. Traders may pay more if they expect huge price volatility that might boost earnings. However, low premiums may suggest poor volatility or market interest.
Option premiums change during the trading day depending on market circumstances, demand, and supply. Thus, traders should monitor option premiums for possibilities and hazards.
References and sources:
Sources for this article include:
Website: https://www.investopedia.com
Options Playbook—https://www.optionsplaybook.com
Options Industry Council (https://www.optionseducation.org)