Hello everyone.
This is Kirk, here again at optionalpha.com and this is the video tutorial for option
premiums.
Again, we’re going to go right into it and talk about some of the basics behind option
premiums.
We’re going to go back to our RB’s combo coupon example because I love RB’s and this
is a really easy way for you guys to understand what an option premium is.
Let’s just say again that we have this roast beef combo coupon for $3.99.
That’s what we can buy roast beef combo right now at RB’s.
If we go in there, we’ll give them the coupon, we can buy it at $3.99.
Let’s say that the regular cost of this combo here is $6.99 for the example.
I have this coupon in my possession and if I want to sell it to you, I could add a premium
onto the price that I have for that option contract.
Remember that this is just a contract right here and I could sell this coupon to you for
$1.
Now, you’d still actually be ahead of the game here because I'd sell it to you for $1,
you would go in and pay RB’s $3.99, so your total investment would be $4.99 and the price
of it regularly is going to be $6.99, so you’re still going to save $2 by buying this coupon
for me if you couldn’t find it yourself for example.
That’s where the option premium comes into play.
It’s that extra price that you pay to acquire that option contract because I’m not going
to give this to you for free.
It has value that’s left in it.
There are two main factors that determine an option contract premium and those two factors
are intrinsic value or the value it has right now and then the extrinsic value, the value
that’s remaining and time decay and volatility, etcetera.
We’re going to go with an Apple stock example like we've been doing and let’s look at
some current options that are trading for Apple.
Now, I always use the last trade.
Some people like to look at the bid and the ask and try to figure out what the in between
trade is, but when I'm looking at the price of an option, I’m always going to look at
the last trade or what the premium is for that particular contract.
You can see I’ve highlighted both of the premiums for the calls which is located on
the left side of this option pricing table and then the puts which is located on the
right side.
And you can see that there are many different prices or many different premiums because
they all relate to where the strike price is in relation to the current market.
You can see that out of the money puts are trading for $7.58 which is $758 and out of
the money calls are trading for $5.95 which is $595.
These are all the different option pricing premiums.
This is what it cost to acquire any of these strike price calls and puts on Apple.
The premium isn't fixed and changes constantly.
Premium you paid today is likely going to be higher or lower than premium yesterday
or tomorrow.
Going back to our example right here, these are the premiums as of this time.
I bet you if I pull up this pricing diagram here today (and this a couple of days after
I actually pulled this information when I’m making this video) that these premiums would
be wildly different and that's because the market is always changing.
Everything that is a premium yesterday could be higher or lower than tomorrow.
When we talk about premiums, we want to talk about and focus on the net debit or net credit.
Again, net debit means that you’ve spent money at the end of all of your transactions
to enter the strategy.
This could be a debit spread, an iron condor, anything like that, a butterfly, a ratio spread,
anything.
Anything that you end up actually spending money on is going to be a debit spread.
To make money on these types of option strategies, there must be an increase in the value beyond
the price that you paid before expiration.
That makes sense, right?
If you buy a stock, the only way to make money is that the value of the stock goes up.
It’s the same thing with options.
If you pay a premium and you actually outlay that premium as a net debit, then to make
money on that option trade, you need the value of those options to go up.
On the other hand, if you have a net credit, this means that you begin with a credit of
money to your account and that to make money in this option strategy, you have to have
decay in value below the price you paid at or before expiration.
Again, just like shorting a stock, when you short a stock, you sell it high and you want
the value to go lower, so you can buy it back in.
The same thing applies with options trading.
If you have a strategy where you actually get money at the end of the day, whether that’s
a credit spread, an iron condor, naked puts and calls, when you receive money or you receive
that option premium, you can’t get any more than that, but you can keep all of it if the
value of those options decay and absolutely completely disappear before expiration.
That's really the two big differences between option premiums.
You’re going to have premiums that you outlay and those are net debits and then premiums
that you take in which are net credits.
Again, option premiums are very, very simple.
They’re simply the price that you pay to enter into a contract or the price that you
receive to sell a contract or an options contract.
Thank you for watching this video.
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