Premium

Premium: A Key Term in Trading

At its most basic level, a premium is a price charged for a privilege. But in the world of trading, the term takes on a more specific meaning. The premium is the sum an option buyer pays the option seller to acquire the rights given by the option contract. This applies to both calls (options to buy assets) and puts (options to sell assets).

Breaking down the Premium

The premium is paid upfront and is non-refundable. It represents the price of acquiring the option, but it is not the only cost associated with trading options. Other components of the premium include the intrinsic value, time value, and the implied volatility of the underlying asset.

The Intrinsic Value and Time Value

Premium prices generally include two main components: intrinsic value and time value. The intrinsic value relates to how much the option is already 'in the money', that is the difference between the strike price and the market price. The time value is how much the investor is willing to pay for the potential future growth of the asset until expiration.

The Role of Implied Volatility

Implied volatility plays a significant role in the pricing of a premium. A higher implied volatility generally leads to a higher premium, and vice versa. The logic behind this pattern is that increased volatility makes it more likely that the option will move 'in the money', thus increasing the premium.

Premium Trading Strategies

By understanding the premium, traders can implement various strategies. Those who expect a sharp move in the market may choose to buy options, paying the premium. On the other hand, those who expect little movement may choose to sell options, collecting the premium.

The Bottom line

Premium — it's one of the key terms in the trading world. It refers to the upfront cost paid by the option buyer for the rights granted by the option contract. Understanding the factors that determine the premium — intrinsic value, time value, and implied volatility — can assist a trader in making informed investment decisions.