What is a Premium in Derivatives?
In the context of derivatives, such as Options and Futures, a premium is a crucial concept. Understanding how premium works can help you finetune your investment strategy and maximise profits while investing in derivatives.
In the context of a financial market, derivatives are financial instruments such as contracts or securities and trading in derivatives is centred around buying and selling these derivatives. They derive their value from an underlying asset, index, interest rate, or any other financial variables. For traders, these instruments have multifarious purposes, including speculating on future price movements, hedging against price fluctuations, and managing financial risk. The main types of derivatives include options contracts, futures contracts, swaps, and forwards. For the purposes of understanding premiums, we will only look into options and futures contracts.
Outlining premiums in derivatives
Let's explore the two primary contexts in which a "premium" is used in derivatives:
The premium in options contracts such as stock options or commodity options refers to the price set between the option buyer and the option seller. This price is set for two things-
- In the case of a call option, you gain the right to purchase
- in the case of a put option, you gain the right to sell
The right is applicable towards the underlying asset at a specified strike price. At times, the premium is also referred to as the "option price" or "option premium".
If you’re purchasing an options contract, the premium is the upfront cost associated with acquiring it. Here, if the buyer chooses not to exercise the option, the premium forms a part of the maximum potential loss they incur.
Let us understand this with an example. If the option ABC 1000 call Sep 23 is trading at Rs. 20, it means you will pay Rs. 20 for the right to purchase one share of ABC at a strike price of Rs. 1000 with the maturity on the final Thursday of September 2023. However, since options are traded in lots and if the minimum lot size of ABC is 100 shares, your total premium will stand at Rs. 20 x 100 = Rs. 2000. Therefore, your final maximum potential loss will be Rs. 2000 + brokerage + statutory charges.
Now that you understand the basics, let us explore the three most important concepts associated with the premium of an option.
- Intrinsic value - The intrinsic value makes up a critical component of an Option’s premium alongside the time value. Basically, this is the tangible or the actual value of the option and is derived by subtracting the strike price of the option and the underlying asset's current market price.
- Time value - The time value of an option is another critical component that determines the premium. It represents the additional premium that investors are willing to pay for any potential movement in the future price of the underlying asset, the time till the option expires, and the option's volatility. Essentially, it is the price of the underlying uncertainty as well as the potential to gain more intrinsic value before the option’s expiration.
- Implied volatility - Implied volatility, as a key driver of the time value component, has an impact on an option's premium. The higher the implied volatility is, the higher the option premiums are. The converse is also true with lower implied volatility leading to lower premiums. It is critical for you to consider the option’s implied volatility when making strategies as it has a significant impact on its cost and potential profitability.
As you can infer, options closer to the current market price of the underlying asset or with higher implied volatility and longer expiration dates tend to have premiums higher than others. Now, let us understand premiums in terms of Futures contracts.
Futures Premium (Basis):
The term premium is also called the basis in the context of futures contracts. It indicates the difference between the futures price of an underlying asset and its current spot price. The premium is considered positive, and the market condition is considered a “contango” when its future price is higher than the spot price. A contango indicates that traders and investors are willing to pay this premium in lieu of the convenience of owning the underlying asset in the future.
The reverse concept of a contango is “backwardation”. This happens when the future price of the underlying asset is lower than its spot price making the premium negative. In backwardation, investors are willing to accept a negative premium, or a discount, to own the asset in the present time. The premium or basis in futures contracts is volatile. It can fluctuate based on factors like storage costs (for physical commodities), interest rates, supply and demand dynamics, and expectations related to future asset prices.
In summary, in derivatives trading, the term "premium" typically refers to:
- Either the price paid for an options contract, or
- The difference between the futures price and the spot price of the underlying asset in futures contracts.
As a trader, you must understand these concepts. It is critical for your participation in derivatives markets, whether you are engaged in options trading or are delving into futures trading.