DEFINITION of Spot Premium
The spot premium is the money that an investor pays to a broker in order to purchase a type of exotic option known as a single payment options trading (SPOT) option, most typically used in foreign exchange (forex) markets. With a SPOT option (also called a binary option) the investor chooses the payout he wants and the market conditions he wants to occur in order to receive that payout. The broker then sets a premium for the option based on the probability of the investor's predictions occurring.
The spot premium on a SPOT option is usually calculated as a percentage of the payout. After the broker sets the premium, the investor can choose to go ahead and buy the option if he or she is satisfied with the price, or to decline if they thinks the price is too high. If the payout conditions do occur, the investor collects his payout. If they not occur, the investor will lose the spot premium. However, no matter what happens in the market, the most a trader can lose is the spot premium itself.
BREAKING DOWN Spot Premium
A SPOT option is a type of option contract that allows an investor to set not only the conditions that need to be met in order to receive a desired payout, but also the size of the payout he or she wishes to receive if those conditions are met. The broker that provides this product will determine the likelihood that the conditions will be met and, in turn, will charge what it feels is an appropriate commission. This type of arrangement is often referred to as a "binary option" because only two types of payouts are possible for the investor: 1. The conditions set out by both parties occur, and the investor collects the agreed-upon payout amount; or 2. The event does not occur and the investor forfeits the full premium paid to the broker. The broker for the contract, given that the terms of the SPOT option are agreeable with both parties, will then accept a percentage of that projected payout in the form of the spot premium and the investor can proceed to buy the option.
For instance, say a trader thinks that the CHF/USD will not break below 1.40 within the next two weeks, he or she would pay a certain spot premium to a broker and then collect the agreed upon payout in 14 days if this scenario turns out to be true. However, if the CHF/USD does break below 1.40, during that time frame, the trader will lose out on the full amount of the spot premium
Usage of SPOT options and the spot premium has declined substantially following the global financial crisis that began in 2008.