LEARN HOME / LESSON 3
Premium can be payment for danger
A high option premium can look attractive. Often it means the market expects a bigger move, a known event, or harder execution.
Compare two made-up contracts
ILLUSTRATION Both contracts pass the early strike-distance test. They still differ.
| Check | Contract A | Contract B |
|---|---|---|
| Premium | $1.80 | $1.50 |
| Recent movement | Lower than option-implied movement | Higher than option-implied movement |
| Known event before exit | No | Yes |
| Quoted spread | Tighter | Wider |
| First reading | Continue checking | Reject or investigate the event and execution risk |
Contract A still needs cash, liquidity, position-size and concentration checks. Contract B may pay more because the buyer sees a risk that the seller should not ignore.
Five reasons to reject premium
- An event sits before your planned exit. Earnings, a court ruling, a product decision, or a policy event can move a price sharply.
- The spread looks too wide. A wide gap between bid and ask can turn an apparent premium into a poor fill or costly exit.
- Too few contracts trade. Weak open interest or volume can make both entry and exit harder.
- The required cash creates concentration. One contract can tie up a large share of a small account.
- The premium only looks good after annualising a short period. A short-lived credit does not equal a yearly return.
What to look at
- Is the option pricing unusually large movement compared with the share's recent movement?
- Does a known event arrive before the planned exit?
- Can you enter and exit with a sensible limit order?
- Do open interest and volume support a practical exit?
- Does the full cash reserve leave room for other risks?
A contract pays more, but its bid/ask spread is wide and earnings arrive next week. What is the first sensible action?
Reject it or stop and investigate. The extra premium does not cancel the execution and event risk. A reader should never relax a hard check just because the premium is rich.
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