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How is Option Premium Calculated When There Are Multiple Trades

26 Jul 2023

Introduction

Engaging in options trading offers lucrative opportunities in the stock market for investors. But engaging in options trading necessitates a comprehensive understanding of its mechanisms. A crucial element in options trading is the option premium.

Option premium represents the price paid by the buyer to the seller for the right to purchase or sell a fundamental asset at a certain time and price. It relies on multiple factors like the underlying asset’s price, time until expiration, volatility, and interest rates.

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Calculating the option premium can be challenging, especially when multiple trades are involved. Here we'll demystify option premiums and gain useful insights into their calculations. If you are ready, let’s delve into the intricacies of option premium calculations. 

What is the option premium?

The option premium represents the price paid by an option buyer to acquire the right to buy or sell an underlying financial instrument. It serves as compensation received by an option writer in exchange for the obligation to buy or sell the option contract. Evaluating the attractiveness of an option contract’s price involves considering the premium, along with any intrinsic value, for call options, for instance. 

Option writers, on the other hand, utilise premiums to hedge their positions and enhance their returns. This is possible because option premiums offer protection against losses resulting from a decline in the price of the underlying asset. When you reduce the impact of adverse events like a drop in portfolio instrument prices, premiums act as a safeguard. 

How is the option premium calculated during multiple trades?

The calculation of the option premium is based on adding together the average price of all executed orders for the specific contract. Let’s consider this scenario to learn how to calculate option premiums:

Two lots of “HDFCLIFE21JAN700CE” were carried forward and sold the next day. Moreover, an inter-day trade was conducted for the same contract, which results in a total of four executed orders.

The opening balance for these orders is Rs. 1,51,599, with available cash of Rs, 2,15,784, a used margin of Rs. 58,350, an available margin of Rs. 2,15,784, and an option premium of Rs, 64,753

In this case, the used margin can be calculated in two ways:

  1. Based on the difference between the premium received and paid, 
  • Amount of all sell trades (premium received): 88,300 [28500 (1000*28.50) + 28,900 (1000 * 28.90) + 30,900 (1000 * 30.90)]
  • Amount of all buy trades (premium paid): 29,950 (1000 * 29.95)
  • Used margin difference: 58,350 (premium received minus premium paid)
  1. FIFO (First in, First Out) method:
  • Total from the two carried forward positions sold: 57,400 [28,500 (1000 * 28.50) + 28,900 (1000 * 28.90)]
  • Intraday trade profit: 950 (30.90 - 29.95 * 1000)
  • Total used margin: 58,350

The option premium can be calculated as follows:

  • The average sell price of all three trades: 29.4333 (88,300 / 3000)
  • The amount credited for two lots sold: -64753.26 (2200 * 29.4333)

The minus (-) sign indicates the amount credited, not debited, for both the used margin and option premium. 

Conclusion

Understanding how option premium is calculated is essential for options traders. When traders consider the option premium, they can assess the risks and potential profits of their positions. Traders can access a wide range of tools and resources to help them estimate the option premium, taking into account the current market conditions.

In the complex and ever-changing world of options trading, staying well-informed about the components of option premiums is essential. It is crucial to have a comprehensive understanding of how option premiums are computed, along with the factors impacting their value. This will help traders make informed decisions and enhance chances of financial success.

 

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