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Premium and Risk in Options Trading
Premium and risk in options trading go hand in hand. The premium that an option buyer pays conveys the rights of the option. The premium is set by the market and is not a standardized term or condition of the option. It is a payment in full for the right but not the obligation to buy or sell the underlying equity at an agreed upon price. This price is called the strike price and does not change throughout the duration of the options contract. The risk in options trading has to do with the degree to which the market price of the price of underlying equity may change during the duration of the contract. The price that the buyer pays for the option is first based up the relationship between strike price and market price and second based upon the combined assessment of many traders in the options market as to the likelihood of the market price changing. Appraisal of premium and risk in options trading is part of risk management in options trading.
The Market Determines the Premium
An options premium, whether it is in writing puts in options trading, writing calls or buying either, is never fixed by the options markets or their governing bodies. The premium is subject to continual change in response to traders’ opinions as to how trading conditions and economic forces affect the value of the option. The current value of the underlying equity, compared to the strike price, determines if the option is “in the money” or “out of the money.” A call option is in the money when the market price, also called the spot price, is higher than the strike price. A put option is in the money when the strike price is higher than the spot price. In each case in the money means that the option is worth more money than when it was first purchased. Anyone holding the option when it is in the money is very likely not going to be willing to sell the option for less than the difference between strike price and spot price unless he or she anticipates some drastic event that will change the value of the equity. That brings us to the time value of the option.
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