The premium is the price an option buyer pays for an option contract. In programmer terms, it resembles paying for an API key: the key grants a conditional buy() or sell() capability, while the premium is spent whether or not the option is exercised. An option buyer’s maximum stated loss is the premium, but the contract’s value depends on the underlying asset, strike price, and expiration date. section 1.2.7
Use the premium to distinguish the buyer’s defined cost from the seller’s obligation:
- Buying a put option resembles insurance: the buyer pays the premium for the right to sell at the strike price if the asset falls. section 1.2.7 section 7.4.1
- Buying a call option provides the right to buy at the strike price, offering upside exposure with a limited upfront cost. section 1.2.7 section 11.2.3
- Selling an option produces premium income but creates an obligation; a short put can require buying a sharply fallen stock at the strike price. section 1.2.7
- Treat the premium as a cost, not a prediction: options can express a volatility view without identifying the exact direction of a stock move. section 11.2.3
ACME downside hedge
Pedro owns ACME shares bought at $100 and pays a premium for a put with a $95 strike before an earnings call. If ACME remains above $95, the premium functions like unused insurance. If ACME falls below $95, the put gives him the right to sell at $95, reducing the downside. The protection still has a cost, and the result depends on the contract terms and market movement. section 7.4.1
