What Is a Step Premium Option?

A step premium is a price paid for the purchase of an options contract that is due to be paid in a series of installments made over time as the expiration date or the strike price of the option approaches.

More common are the premiums paid for vanilla options, which require the entire amount to be paid up-front when the trade is initiated.  A step premium option is a type of structured option.

Key Takeaways

  • A step premium option allows for an options contract to be paid for over a set of installments.
  • These types of options trade over-the-counter (OTC), where additional features can be added to customize the contract.
  • Step premium options generally cost more than plain vanilla options, which require payment at the time of the agreement.

Understanding the Step Premium Option

An options buyer may choose to buy a step premium option simply to spread the cost over a longer period of time. Another trader may choose to sell (write) a step premium option because the total premium will be larger than for a comparable vanilla option. 

Step premium options are traded over the counter (OTC), so the parties involved in the transaction can create their own terms.  Options may be traded either over-the-counter or on a public stock exchange. Flexible contract arrangements such as step premium options are a feature of the over-the-counter market. In over-the-counter trades, the contract for the option spells out the amount of the premium and when it will be paid. A step premium option is more expensive than a comparable vanilla option.

Since step premiums can be customized by the parties involved, instead of paying the premium as equal amounts of time pass, the parties may agree on payment when the underlying asset reaches certain prices.

Other Flexible Arrangements

An even more expensive arrangement is the contingent premium option. In this case, the investor does not pay a premium if the option expires out of the money (OTM), or with no intrinsic value.

Given the flexibility that is possible, a wide variety of options have been designed to meet different investment needs. Their premiums reflect the unique risks and rewards associated with each type of option.

Example of a Step Option Premium

Say an option buyer wants to initiate a trade in a step premium option. The options will expire in four weeks.

A vanilla option with the parameters the traders want has a $1 premium. Since the trader wants a step option, the seller requests $1.10.

The buyer agrees and purchases 10 contracts (of 100 shares each) for a total cost of 100 x 10 x $1.10 = $1,100. As part of the agreement, the option buyer will pay a quarter of the premium, or $275, at the end of each week. At the end of four weeks, the premium will be paid off in full.

A Second Variation

As another example, if the above option is a call, the strike price is $45, and the underlying stock currently trades at $44, the premium installments may be due each time the underlying moves $0.25 closer to the strike. If the underlying rises to $44.25, the first premium is due. When it rises to $44.50, another premium payment is due. If the underlying doesn't reach the strike price, any remaining premium is due at expiration.