What is a Contingent Premium Option?

A contingent premium option is a special kind of financial contract. It’s a complex option bought and sold directly between two parties, not on a regular stock market. The unique thing about it is that the buyer only has to pay the seller the premium (price) for the option if it ends up being “in the money” when the contract expires.

In-the-money means that the option would make money if the buyer chose to exercise (use) it based on the current prices in the market. Usually, with options, the buyer has to pay the premium upfront, no matter what. However, with contingent premium options, they wait and see if the option will be profitable before paying.

Also Known As Pay Later or When-In-The-Money Options

Contingent premium options have a couple of other names that people use for them sometimes. They might be called “pay later options” since you pay the premium later only if the option ends up being in the money. Or they could be called “when-in-the-money options” for the same reason – you only pay when the option is in-the-money at expiration.

How Contingent Premium Options Work

Okay, so how exactly do these unique options work in practice? Let’s break it down step-by-step:

Step 1: Making the Deal

First, the buyer and seller have to agree on the terms of the contingent premium option contract. They decide things like what underlying asset the option will be for (like a stock or commodity), the strike price (the price the asset needs to reach for the option to be in-the-money), the expiration date, and of course, the premium the buyer will pay the seller if the option ends up in-the-money.

Step 2: Waiting and Watching

Once the contract is made, the buyer and seller just have to wait and watch what happens with the underlying asset’s price. The buyer hopes the price will move past the strike price by expiration, so their option will be in-the-money. The seller is hoping it won’t, so they won’t have to do anything, and the option will just expire worthless.

Step 3: Expiration Day

When expiration day comes, it’s time to see where things stand. There are three possibilities for what could happen:

1. The option is in-the-money. If the underlying asset price is better than the strike price, meaning the option is in-the-money, then the buyer has to pay the premium to the seller, and then they’ll exercise the option to make their profit. Even if the profit would be less than the premium they have to pay the seller, they’re still obligated to go through with the deal.
2. The option is out-of-the-money. If the underlying price never reached the strike price, then the option expires out-of-the-money. That means the buyer doesn’t have to pay anything and the seller keeps the whole premium.
3. The option is at-the-money. If the underlying asset price is exactly at the strike price at expiration, the option is considered “at-the-money.” In most cases, this means the option expires worthless just like if it was out-of-the-money. The buyer wouldn’t want to pay the premium to exercise an option that wouldn’t make them any profit.

So really, the buyer of a contingent premium option is only on the hook to pay the premium if the option ends up being solidly in-the-money. That’s the key difference compared to a regular option where they’d have to pay the premium upfront.

Example of a Contingent Premium Option

Here’s a hypothetical example to help explain how a contingent premium option could work:

• XYZ stock is trading at $50 per share.
• A buyer and seller make a deal for a contingent premium call option on XYZ stock with a $55 strike price that expires in one month.
• They agree the buyer will pay a $2 per share premium to the seller if the option ends up in-the-money at expiration.

After one month passes, let’s look at a few different ways it could turn out:

• If XYZ is trading at $60 at expiration, the option is in-the-money by $5. The buyer has to pay the $2 premium to the seller, and then they’d exercise the option to buy shares at $55. Even though their profit is only $3 per share after paying the premium, they’re still obligated to go through with it.
• If XYZ is trading at $50 at expiration, the option is out-of-the-money. It expires worthless and the buyer doesn’t owe the seller anything.
• If XYZ is trading right at $55 at expiration, the option is at-the-money. The buyer wouldn’t want to pay $2 just to not make any profit, so the option expires worthless like it was out-of-the-money. No premium is owed.

The main appeal of contingent premium options for buyers is that they provide a way to speculate on the price of an asset without having to cough up as much money upfront. The trade-off is that they still have to go through with the deal and pay the premium if the option is in-the-money at all at expiration, even if their profit is less than the premium they owe.

Pros and Cons of Contingent Premium Options

Contingent premium options have some distinct advantages and drawbacks compared to regular options. Let’s take a look at some of the key pros and cons:

Pros

• Limited downside for buyers. The big draw is that buyers only have to pay if their option ends up being in-the-money. If it expires worthless, they don’t lose the premium like they would with a regular option.
• Potential for high returns. If the underlying asset moves strongly in the direction the buyer predicted, contingent premium options can provide the same high returns as regular options.
• More accessible. Delaying the premium payment makes these complex options accessible to more buyers who may not have as much capital to invest upfront.

Cons

• Seller takes on more risk. The seller of a contingent option doesn’t get paid the premium upfront, so they’re taking on the risk of an uncompensated loss if the option expires worthless.
• Higher premiums. To make up for the extra risk, sellers usually charge a higher premium compared to regular options. So buyers have to pay more if the option does end up being in-the-money.
• Lack of regulation. Since contingent premium options are traded directly between buyers and sellers over-the-counter without going through a stock exchange, there isn’t as much oversight and regulation from the authorities. That means there could be a higher risk of shady practices.
• Complexity. These exotic options can be confusing compared to regular options. The unusual premium payment structure might be harder for less sophisticated investors to understand.

Are Contingent Premium Options Right For You?

So who should consider trading contingent premium options? They can be most appropriate for:

• Buyers who are confident in their predictions but want a little more leeway in case things don’t go exactly how they expected before they have to pay up
• Buyers with less upfront capital who still want to make complex options trades
• Sellers who really understand the risks involved and feel the extra premium is enough to compensate them for taking on uncompensated loss potential

As with any complex financial derivative, it’s really important to make sure you understand how contingent premium options work before diving in. If you’re still fuzzy on the details after reading this, you might want to do some more research before proceeding. And of course, never risk more money than you can afford to lose.