What is premium in Derivatives?

In the financial market realm, derivatives are financial instruments like contracts or trading and securities in derivatives encircled around purchasing and selling these derivatives. They take their value from any interest rate, asset, or index that might be underlying.

For traders, these instruments have purposes that are multifarious, including speculation on future price movements, managing financial risk, and hedging against price fluctuations. The main kinds of derivatives include swaps, options contracts, forwards, and future contracts. To understand premiums, we will look at Premium in derivatives.

We all pay option premium when we buy options and receive option premium when we sell options. Have you wondered about the option premium meaning and its significance? Why do options command a premium, what exactly is this premium, and who determines this premium amount? When we talk of premium in derivatives, we are referring to option premium because options are asymmetric. Let us just dwell on that for a moment.

In a futures transaction, the buyer and the seller of futures have equal rights and obligations. However, in options, the buyer has the right while the seller has the obligation. For this right without obligation, the buyer pays the option premium to the seller, which is a kind of sunk cost. When you trade options in the F&O market, the trading price is nothing but the option premium, which is the price of the right without the obligation. In other words, the option premium is the price at which that particular right is traded and moves up and down based on whether the right is more valuable or less valuable.

Premium in Futures Trading

The sum of money you pay when you are entering a Futures contract with a seller is known as the margin. While the future contract you bought is trading at a higher value compared to the amount you paid, it is acknowledged to be at a premium.

Time value leads future contracts to trade at a comparatively higher price, typically a premium to the spot price. You must remember that it is called a Futures premium only when referring to currency derivatives and equity.

The formula to evaluate the PremiumPremium in future is :

Futures Premium= Current Market Price - The price paid originally

Premium in Options Trading

When you want to purchase options, you pay a premium to the one selling to attain the right of the asset, which is underlying and not the obligation. The term for this is known as options premium.

It is paid to the call option sellers and put option purchasers as they have risks that are unlimited in case the put option sellers/ call option buyers decide to execute their contracts. When traders purchase or sell an option, they determine the risk by its Premium or cost.

In case the contract is not executed, the Premium is an earning for the put option buyer or the call option seller. Options and Futures are meant to safeguard you from all the underlying price movements of financial assets, as the exposure is indirect and limited.

Factors that Affect Premium in Futures & Options Trading

The Futures and Options trading premier is poised to change depending on various factors. These factors are vital for you to understand so you can play around with the premiums smartly.

• We all have heard the saying, 'Time is Money.' This is particularly true for the case of premium pricing. The longer there is for expiration, the higher the premiums will become. Options that will not expire anytime soon have an increased possibility of being profitable. This is why there is high pricing on option premiums.
• Both Options and Futures come from the underlying value irrespective of whether it is an index, stock, or commodity. It is why the underlying value compared to the futures or options' strike price impacts the premiums.
• Volatility is one of the most significant factors of Premium in Futures and options. Volatile markets may lead to notable price swings when option premiums rise.
• The government-set interest rates are known to have a say in Premiums for both options and futures.in case there is a high-interest rate, the premiums will be higher. The opposite happens when the interest rates are very low.

How to Trade Options and Futures with Premium?

While there are a few options that you may try, going with the mobile application is your best bet. Utilizing a mobile application will save you a lot of time, money, and effort on your trades. You may sell or purchase the derivatives as soon as you notice a good trade, even if you are travelling. Many features and enhanced options chains may addict you to discovering promising futures and options trade at your fingertips.

Wrapping Up

So there you have it; we finally explained what is Premium on derivatives. The term premium generally refers to either the price paid for an options contract or the mere difference between the spot price and the future price of the asset underlying in Futures contracts.

Importance of premium in Derivatives?

Options premium is the price paid by the buyer of the option to the seller of that option contract. Now, the option premium is always quoted on a per-share basis. So, when you say that the RELIANCE 1200 call Jun-21 is trading at Rs.18, it means that you need to pay Rs.18 to buy the right to buy 1 share of Reliance Industries at a strike price of Rs.1200 and the contract will mature on the last Thursday of June 2021. Since options are traded in lots and the minimum lot size of Reliance is 250 shares, if you buy 1 lot of the above Reliance contract, you need to shell out Rs.4,500 (250 x 18) as the total premium.

This amount of Rs.4,500 plus the brokerage and statutory charges will be your maximum loss on this one lot of Reliance call option, irrespective of how low the stock falls. In other words, the option premium also shows the maximum amount that the buyer of the option can lose in a worst-case scenario. Now to understand option premium from the right perspective, you need to understand 3 very important concepts about option premiums.

Let us take off from here on

1. The first important aspect of option premium is intrinsic value. What is meant by intrinsic value? In simple terms, the intrinsic value of an option contract is the difference between the strike price and the market price of the underlying stock. Intrinsic value can be zero, but it cannot be negative. For example, if you are holding Rs.300 strike Tata Motors and if the market price of Tata Motors is Rs.310, then Rs.10 (310 – 300) is your intrinsic value. In the case of a put option, the intrinsic value will be (strike price – CMP). In short, the intrinsic value of an option shows you the extent to which the option is in-the-money. Option buyers are only interested in options that are in the money.
2. The second important aspect, and perhaps the most important, is Time Value. Any options premium is a sum of 2 components viz. the intrinsic value and the time value. The time value of an option contract is dependent upon the length of time remaining before the option contract expires. The more time an option has to expire, the higher will be the time value of the option. Let us expand our Tata Motors case, you buy Tata Motors Rs.300 call at Rs.7. Now the price has moved to Rs.310 and the premium has moved to Rs.18. Rs.10 (310 – 300) is the intrinsic value of the option. But what is that additional Rs.8 for? That is time value. On expiration, the time value is zero.
3. The third important aspect of option premium is Implied Volatility. This is different from historical volatility which pertains to the past. Implied volatility or IV is used to signify the volatility that is implied in the option prices at any point in time. IV is used to indicate how volatile the stock price may be in the future. High implied volatility means stock price will face large price swings in either direction and that makes the option attractive to the buyer. On the other hand, low implied volatility means that the stock will not swing too much in either direction significantly and this is more attractive to the sellers of the option. Normally, high implied volatility indicates higher option premiums and lower implied volatility indicates lower option premiums.

Difference between equity and derivatives

As the very name suggests, equity is an asset while derivatives derive their value from an underlying asset like equity or bonds, or indices. By itself, the derivative does not have value because its value is derived from the underlying asset. Equity or stock ownership represents proportionate interest or ownership in a company or business. An equity shareholder gets dividends, capital appreciation, bonuses, rights, stock splits and can also vote on resolutions at the AGM.

Derivatives can be either futures or options and neither of them gives ownership. They are just contracts. You cannot say you are the proportionate owner of Reliance just because you are holding call option on Reliance or you are long on Reliance Futures. These are contracts that will expire on the last Thursday of the expiry month. The derivatives market has an important role to play in the sense that they shift inherent risks to a third party. Derivatives market are supposed to be used for hedging or managing risks, although it is used to speculate as well.

What are different types of derivative contracts

Derivatives contracts broadly can be classified into four categories viz. forwards, futures, options, and swaps. Of course, each of these can be further subdivided, for example, futures can be subdivided into stock futures and index futures. The same is the case with options too. Swaps are not all that popular in India still, at least at the retail level.