What is the Spot Premium?
The spot premium is the money that an investor pays to a broker 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 they want and the market conditions they want to occur to receive that payout. The broker then sets a premium for the option based on the probability of the investor's predictions occurring.
After the broker sets the premium, the investor can choose to buy the option if the price is satisfactory, or decline if they think the price is too high. If the payout conditions do occur, the investor collects the payout. If they do not occur, the investor will lose the spot premium. However, no matter what happens in the market, the most the trader can lose is the spot premium itself.
- Spot premium is the cost of purchasing a single payment options trading (SPOT) option.
- A SPOT option is a binary option with agreed upon terms where the buyer either receives a pre-determined payout if conditions are met, or loses their premium if the contract conditions are not met.
- The spot premium may also refer to the difference between a higher spot price and its associated futures contracts. This is called backwardation.
Understanding the 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 the desired payout, but also the size of the payout sought 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:
- The conditions set out by both parties occur, and the investor collects the agreed-upon payout amount.
- 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, they 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.
Futures Spot Premium
The term spot premium may also be used to refer to a situation in which the spot price of a given asset is greater than the price of the near-term futures contracts for that asset. This occurs when the price now (spot) is greater than the expected price in the future which is determined by the futures contract. This situation is more commonly referred to as backwardation.
Example of Spot Premium
The investor is using a binary options broker outside the US, which typically quotes payouts as a percentage of money invested.
For example, our investor decides to wager $1,000 that the EUR/USD will be trading above 1.15 when the option expires on Friday. If the option is not trading above 1.15, the investor loses the $1,000.
If they are correct, the broker has agreed to pay them $750 (and their initial investment back).
In this case, the investor is not taking possession of the underlying EUR/USD, rather the transaction is a bet with the broker on whether the price of the EUR/USD will be above a certain level or not by a certain date.
If not using a binary options broker, the arrangement may be different since exotic options can be structured however the parties agree. It could be set up that the investor pays a premium of $250 up front. If they lose, they only lose the premium. If they win, they get $437.50 (but remember they paid $250, so the profit is really only $187.50).
In binary options, it is typical to lose more when you are wrong than you make when you win. This is because if a scenario is likely to occur (win) the broker isn't likely to provide a high payout. And if the scenario is unlikely, they will offer a higher payout but only because you are likely to lose.
In both cases above, the loss is bigger than the win. In the first example, you are risking $1,000 to make only $750, and in the second example, the trader is risking $250 to make only $187.50 ($437.50 - $250 because $250 of that payout is just getting the premium back, not profit). This is something to be aware of. Traditionally, traders like to make more on winners than lose on losers as this creates a favorable risk/reward tradeoff.