Premium refers to the price that a buyer pays for an options contract. This price is determined by various factors, including the current market price of the underlying asset, the strike price of the options contract, the expiration date, and the volatility of the underlying asset.
For example, let’s say you want to buy a call option on Company XYZ with a strike price of $50 and an expiration date of one month from now. If the current market price of Company XYZ shares is $55 per share and the option premium is $2 per share, you would pay a total premium of $200 (100 shares x $2 per share) to buy the option contract. The premium represents the maximum amount that you can lose on the trade, as if the option expires out of the money, the premium paid is lost. Conversely, if the option is exercised and results in a profit, the premium paid is a small percentage of the potential profits that could be earned. Traders carefully consider the premium when buying or selling options contracts, as it can greatly affect the potential profitability of the trade.