By Darrell Martin
Anytime there is a change in what you might consider to be normal trading conditions, you probably want to know what is causing the change. Among other things, news announcements can cause sharp declines, but what is important, is taking advantage of premium when the choppiness happens.
When you are looking at the market, especially if you are using a scanner to help you place your trades, you may notice a great deal of premium in the market as a whole. This can make it a little more challenging when you are trying to trade if you don’t know how to take advantage of all that premium. If you are trying to be directional, you can have not only direction on your side, but you can also have premium on your side. Obviously, it is nice to have both of those in your favor.
What Is Premium?
Premium is Time and Expected Volume in a specific option. What does that mean? It sounds complex. In normal option trading, premium would be called extrinsic value. All time value. If you buy an In The Money/Market (ITM) spread, it is like buying an ITM call.
US Tech 100/NASDAQ Example
US Tech was currently trading at a shockingly low 4480, because of the choppiness of the market on the day of this example. If you were to buy at 4485, you would pay five points higher than where the market is actually currently trading. In this example, you are paying five points, with each point worth $10 on a Nadex spread. As a review, on Nadex each tick is worth one dollar and US Tech 100 ticks in dimes or .10. A one tick move (.10 move) is worth one dollar. A one point move is 10 ticks and therefore worth $10. If you are buying at five points higher than the market, you are paying five points of premium. The following image shows the premium being $53.
Pouf!! Money gone?
Does this mean that you are five points down on premium? If you bought NASDAQ right now when it is trading at 4480 and you were filled at 4485, you would be down five points right out of the gate. You are not down five points on premium, but you are basically at a five-point loss. Pouf! Money gone. You would probably be upset about that, because, you would think that if the market is moving in your favor, why doesn’t it appear that you are making anything. The answer is because you bought five points lower than the market was currently trading. The market will have to move five points before you see a profit.
The scenario is if you bought a spread at 4485 and IF AT EXPIRATION, the market was still at 4480, you would be down five points. That is what premium is: it’s that time value. It is time value and it decays over time. It does not just Pouf! And go away. It decays over time.
Since Nadex spreads, as well as options, are expiring assets, the entire extrinsic value is subject to time decay. If everything else remains equal, that time will eat away at the value of the spread or option by expiration, thus reducing the value of the premium. The amount of time decay will increase as the option approaches expiration. A Nadex spread or option has no time value at expiration and is only worth its intrinsic value.
In other articles in this series, the following points will be explained:
How to Calculate Premium
Making versus Paying Premium
Which Contract To Choose
How Being Near A Strike Impacts The Premium in a Nadex Spread Option
Knowing about premium and how it affects your trading is putting premium on your side. For more information, visit www.apexinvesting.com, a service of Darrell Martin.