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Example of Option Premium
Let’s say you want to buy a piece of land that you really like, but you don’t have all the money to buy it right now. You might approach the landowner and offer to pay them a small amount of money upfront as an “option premium”. This is similar to the amount of money someone pays to buy an option contract in the Exchanges like NSE, BSE.
By paying this premium, you’re essentially buying the right to buy the land at a certain price within a specific timeframe. This is like an option contract, which gives you the choice (but not the obligation) to buy or sell something (like a piece of land) at a certain price on a specific date in the future.
Let’s say the landowner agrees to sell you the land for Rs. 10 lakh within the next 6 months. You pay the landowner an premium of Rs. 50,000 for the right to buy the land at that price within the next 6 months.
Option advantage
Now, suppose that after 3 months, the land value goes up and the landowner decides to increase the price to Rs. 12 lakh. Since you paid the option premium, you have the right to buy the land at the original price of Rs. 10 lakh within the next 3 months. This means you could buy the land for Rs. 10 lakh, even though its current value is higher. If you decide not to buy the land, you will lose the premium of Rs. 50,000 that you paid earlier.
On the other hand, if the land value goes down within the 6 months, you might not want to buy the land at the original price of Rs. 10 lakh. In that case, you could simply choose not to exercise the option and lose the premium of Rs. 50,000 that you paid earlier.
Option premium
So, option premium is like the small amount of money you pay upfront to buy the right to buy a piece of land at a certain price within a specific timeframe. Just like buying an option contract in the Indian market, paying an option premium gives you the choice (but not the obligation) to buy or sell something (like a piece of land) at a certain price on a specific date in the future.
