What Is Net Option Premium?
The net option premium is the total amount an investor or trader will pay for selling one or more options and at the same time purchasing others. The combination can include any number of puts and calls and their respective position in each. The net option premium can either be positive, which represents a net cash outflow, or a negative number, which represents a net cash inflow.
The net option premium is useful because options traders often engage in spreads or combination strategies that involve two or more options. Since each individual options contract will carry its own premium (i.e. its market price), the net options premium helps traders understand the total outlay or inflow of money for a transaction with multiple legs.
- Net option premium is the total premium (price) related to an options spread or combination; i.e., involving two or more options contracts.
- For options spreads, one option is bought while another is sold, reducing the net option premium.
- For combinations like straddles and strangles, multiple options are purchases (or sold) together, increasing the net option premium.
The Options Premium
Understanding the Net Option Premium
The net options premium shows a trader what the total outlay or inflow a multi-leg options strategy such as a spread or combination will generate. It can also help the trader tweak the strategy to arrive at a particular total premium amount, including a zero-cost position. Knowing the net option premium is also necessary for calculating the maximum loss and the break-even price for a trade involving multiple options.
Options spreads involve buying one option to sell another. For instance, in a long vertical call spread, one call option is purchased at a lower strike price while one at a higher strike price is sold. This reduces the total net premium as compared with just purchasing the lower-strike call. Spreads, therefore, tend to lower the net option premium.
Combinations, on the other hand, increase the net option premium. A long straddle, for instance, involves purchasing both a call and put at the same strike price and expiration for the same underlying. The net option premium would thus be the addition of the call's and put's individual premia.
Examples Net Option Premium
Covered Call Example
For example, assume an investor wants to take a synthetic covered call position in a particular stock. If the investor pays $2.50 per lot for a put option with a strike price of $55, and then sells a call option at the same strike price for $1 per lot. The net option premium in this example is $1.50 ($2.50 - $1.00).
If, on the other hand, the investor pays $0.50 per lot for a put option with the same strike price, and sells a call option for $1 per lot, then there will be a net cash inflow (a negative net option premium) of $0.50 ($0.50 - $1.00).
Zero-Cost Collar Example
For instance, if the $55 strike put from the example above is trading at $2.50 and the $50 strike put is trading at $1.25, a trader could buy one of the $55 puts and simultaneously sell two of the $50 puts, generating a one-by-two ratio put spread for zero net premium. Of course, as the underlying stock moves or as time passes, the prices of these options will change differently and the value of the spread will move away from zero, either in favor or against the trader.