What is Net Option Premium?
A net option premium is the difference between the price paid to purchase an option and the price received from the sale of a different option.
How Does Net Option Premium Work?
The formula for net option premium is:
Net Option Premium = (Price of Options Sold - Commission on sale) - (Price of Options Purchased - Commission on Purchase)
Let's assume investor X buys 100 options of XYZ Company for $10 and then sells 100 options in XYZ Company for $12. The commission on both the purchase and the sale is $0.50, or $1 total. The net option premium is ($12 - $0.50) - ($10 - $0.50) = $1.00.
Why Does Net Option Premium Matter?
Net option premiums are a critical component in hedging strategies and other tactics designed to mitigate risk. When investors simultaneously purchase and sell options in a given security, they are generally intending to cap both the upside and downside of a position in a security, but they also may be engaging in a little arbitrage.
The idea is that the investor can make "free" money by skimming the net option premium on a position. In other words, because the investor has purchased and sold options on the security, the investor is essentially insulated from the effects of dramatic changes in the price of the underlying security (what he gains in the options sold, for example, he loses in the options purchased). The mitigated risk exposure means that, in theory, the investor can simply buy and sell options on the security and rake in the net option premium in the process.