What it means
An option is a contract that gives its buyer the right, but not the obligation, to buy or sell an asset at a set price before a set date. The buyer pays the seller a price for this right, which is called the premium.
Many strategies combine several options at once, buying some and selling others. The net option premium adds up the cash flows of all the legs.
Premiums received from options sold are positive, and premiums paid for options bought are negative. If the total is positive, the trader has received a net credit, and if it is negative, the trader has paid a net debit.
This number matters for several reasons. In a credit strategy, such as a spread where the trader sells a more expensive option and buys a cheaper one, the net premium is the maximum profit if the options expire worthless.
In a debit strategy, it is the most the trader can lose in a simple spread, and it is also the amount that must be earned back before the trade turns a profit. Companies use options too, for example to hedge currency or commodity prices.
A treasurer who buys a protective option and sells another to offset part of the cost may design a structure with zero net premium, often called a costless collar. Knowing the net premium helps the treasurer budget the cost and explain the hedge to the board.
The nuance is that the net premium is only the cash at the start of the trade. Profit and loss at expiry depend on the price of the underlying asset, and commissions, fees and margin requirements also affect the total result.
Short options can also cost far more than the premium received if the market moves against the trader.
In practice
Real-world examples.
Example
A trader opens a bull call spread by buying a call for $5.00 and selling another for $2.00 per share. The net option premium is -$3.00 per share, a net debit of $300 on one contract. The trader's maximum loss on the position is that $300 plus fees.
Example
An airline treasurer buys a fuel price protection option for $400,000 and sells a separate option that brings in $400,000. The net premium is zero, so the hedge costs nothing at the start. The finance director notes that the sold option limits the benefit if fuel prices fall sharply.
Example
An investor writes a covered call on shares she owns, receiving $1.20 per share on 1,000 shares. The net premium is $1,200 received. She keeps this even if the option is not exercised, but gives up gains above the strike price.
Formula
Calculation
Net option premium = premiums received from options sold - premiums paid for options bought
A trader sells one call option at a premium of $6.50 per share and buys another call option at a higher strike for $2.50 per share. Net premium per share = 6.50 - 2.50 = $4.00 net credit. One contract covers 100 shares, so the net credit is 4.00 x 100 = $400. If the options both expire worthless, the trader keeps the full $400, before fees.Case study
Seen in the real world.
Meridian Orchards is a fictional exporter with sales in a foreign currency. In this illustrative story, its treasurer wanted protection against a falling exchange rate but the quoted cost of a simple protective option was $90,000. To reduce the cost, she also sold an option that would give up gains if the currency rose strongly, which brought in $60,000.
The net option premium was therefore -$90,000 + $60,000 = -$30,000, a net debit. The board approved the structure because it cut the up-front cost by two thirds and still protected against a serious fall. The treasurer explained clearly that the sold option meant some of the upside would be given up.
Watch out
Common mistakes.
- Assuming a net credit means no risk. Selling options can create large losses if the market moves sharply against the position.
- Ignoring costs. Commissions, fees and the margin required for short options reduce the true result.
- Forgetting the contract size. A premium of $4.00 per share is $400 on a standard contract of 100 shares.
Questions
People also ask.
What is the difference between a net credit and a net debit?
A net credit means you received more premium than you paid, and a net debit means you paid more than you received.
Is the net premium the same as the maximum profit?
Only in some credit strategies, because in others the profit depends on the move in the underlying price.
Can a company hedge for zero net premium?
Yes, structures such as a collar can be set up so the premium paid equals the premium received, though the company gives up some potential gain.
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