What is a Step Premium Option
A step premium is a type of option where the cost of purchasing the option, called the premium, is paid gradually as the expiration date or strike price of the option approaches. This differs from vanilla options where the entire premium is paid when the trade is initiated.
Breaking Down the Step Premium Option
Step premium options are traded over the counter, allowing the parties involved can create their own terms. The contract for the option spells out how much premium must be paid and when. A step premium option is more expensive than a comparable vanilla option, but less expensive than a contingent premium option. With the latter, the investor does not pay a premium if the option expires out of the money.
A step premium option is considered a structured option. A wide variety of options exist to meet different investment needs, and their premiums reflect the unique risks and rewards associated with each type of option.
Step Option Premium Example
A person may choose to buy a step premium option if they want to spread out their initial cost over a longer period of time. Another person may choose to write or sell a step premium option because the overall premium they receive is larger than with a comparable vanilla option, even though with the step premium they receive the money over a longer period of time.
Assume an option buyer wants to initiate a trade in a step premium option. The option 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 of the step option 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 entire premium will be paid.
Since step premiums can be customized by the parties involved, instead of paying the premium as equal amounts of time pass, the parties may instead agree on payment when the underlying reaches certain prices. For 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 get paid 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.